Momentum investing is a technique which is constructed on the uncomplicated assumption that economic assets such as shares, indices, derivatives, bonds, commodities that are displaying strength will continue to go up at least in the quick term, so we get these these securities when promoting these assets that are displaying low returns. Thus, possessing a portfolio of such assets really should present greater returns than that of the broader marketplace return. Let us go over the identical in detail.
Mechanics behind momentum investing
This investment technique is not new. The mechanics behind this technique is based on the investment philosophy of cutting your losses and letting your winners ride. In other words, the idea of momentum investing states that quick-term functionality is repeated with winners continuing to be winners and losers continuing to be the losers. It is purely based when cost action momentum is higher. High momentum is exhibited in the marketplace when the cost advances or declines more than a wide variety in a quick period of time.
Cause of momentum impact
According to behavioural finance literature, investors generally overreact or underreact to information and facts which leads to cost adjustments and therefore lead to cost inefficiencies. Another plausible cause could be the marketplace timing. For instance, investors could react really gradually in response to new information and facts concerning a stock and then realise the value and act hurriedly upon it, which creates momentum. Generally, such momentum exists for a quick-term, i.e., in between six to 12 months.
Types of momentum
There are two varieties of momentum investing strategies—time-series or absolute momentum and cross-sectional momentum. Under time-series momentum, the functionality of an asset is compared to its personal historical functionality. For instance, ranking of shares on their personal 12- month functionality would provide a list of shares that have rallied the most.
Time-series momentum could be identified by maintaining a particular profit percentage as threshold, and frequently these shares / assets which have exceeded the threshold are purchased. In case of relative momentum, the concerned assets functionality is compared with other comparable asset classes. For instance, gold rallied more than a year by 15% whereas equity rallied 12% in the course of the identical period. So, the relative momentum of gold is greater than that of equities.
Advantages and related dangers
Momentum investing is unique from that of the regular worth investing philosophy of obtaining low and promoting higher. The significant benefit of this technique is that investors are obtaining an asset which is currently moving up. So, there is no need to have to recognize an undervalued asset and wait for the marketplace to recognise the identical to make profit. Another benefit is that there exists a possible for higher income inside a quick span of time. As investors are generating use of the marketplace volatility to their benefit, the momentum investing aids to maximise the return on investment.
Investors really should comprehend the related dangers of following momentum investment technique. Under this strategy, one is investing in an asset class purely based on current obtaining behaviour of other marketplace participants. There is no assurance that such obtaining behaviour will continue to push the cost greater.
A significant quantity of empirical proof and back-testing techniques assistance that momentum trading techniques are lucrative and when making use of such techniques investors really should preserve in thoughts the above discussed elements.
The create is a professor of finance & accounting, IIM Tiruchirappalli