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What Is Momentum Investing?

Investing isn’t a one-size-fits-all proposition and there are lots of different approaches you can take. Value investors, for example, focus on undervalued companies while buy-and-hold investors buy securities and hang on to them over the long haul. Momentum investing is an entirely different animal and it’s geared toward investors who prefer active to passive investments.

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Momentum Investing Explained

Momentum investing is all about cashing in on trends in the market. The basic premise centers on buying stocks whose prices are on the rise and selling off those that are in decline. Assuming that the trend continues, momentum investing makes it easier to predict which investments are likely to yield the biggest returns. Essentially, investors who go this route bank on securities to keep their winning streak intact.

How Does it Benefit Investors?

What Is Momentum Investing?

On the surface, momentum investing seems fairly simple. The idea is that you take a long interest in stocks that are hot and short sell the ones that are cooling off. As a stock’s price goes up, so do the gains and it’s the opposite when the value goes down. So why would a savvy investor want to go the momentum route? It all comes down to the kind of returns this strategy can produce.

If you’ve trained your eye to spot trends, momentum investing makes it possible to not only match the market but beat it. Timing and patience play a big part in whether or not investors are able to achieve success. In order to make momentum investing work, you need to be able to hold onto the stocks that have been performing the best over the past three to 12 months and know when to short sell the duds.

Investors who are adept at picking out trends in the market stand to see some sizable gains by riding the wave of a particular stock. At the same time, it’s important to rebalance periodically to make sure you’ve got the right asset allocation in your portfolio. The key is knowing when to change up your holdings before a stock runs out of steam.

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What Are the Risks?

Momentum investing is like playing a game of hot potato. The biggest risk for investors is a reversal of a stock’s current trend. This can be especially problematic if you’re concentrating a significant amount of your investments in specific sectors, such as finance, energy or biotech.

If the sector as a whole stumbles, that can create a ripple effect that can send a soaring stock into a downward spiral. In periods when the market is more volatile than usual, momentum investing has the potential to backfire, resulting in big losses for investors.

The other big threat to watch out for is internal. When the market has a tendency to be unstable, that can trigger fear, which in turn may lead investors to make rash decisions about buying and selling. Being able to separate your investment goals and philosophy from what everyone else is doing can keep you from making the wrong move with momentum stocks. And because frequent trading generally incurs fees, momentum investing can be a costly undertaking.

Related Article: What Is Value Investing?

The Bottom Line

What Is Momentum Investing?

The momentum investing approach isn’t right for every investor. Your ability to earn sizable returns will ultimately come down to how much time you’re willing to put into researching the market. If you can’t commit to doing your homework on specific stocks and mapping out your exit strategy, you may be setting yourself up for more risks than rewards in the long run.

Photo credit: ©iStock.com/Philartphace, ©iStock.com/suphakit73, ©iStock.com/franckreporter

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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