Momentum investing involves hawkishly watching the market and betting on discrepancies in financial reports.
Momentum investors are data-driven traders who look for patterns and discrepancies in a company’s financial data to inform their purchasing decisions. The goal is to capitalize on improperly valued equities, be they over- or undervalued.
On paper, this strategy works to investors’ advantage by racking up profits over months, rather than a period of years.
Momentum investors are all about winning by betting on the numbers. As a rule, they believe that growing stocks will continue to grow, while stocks that consistently show losses will continue to lose. Their method flies in the face of the efficient-market hypothesis (EMH), which states that asset prices reflect all available information.
One of the most common strategies that aggressive momentum traders look to is shorting stock, as it quickly and sharply increases returns to make up for losses elsewhere. Investors utilize this strategy when they believe a stock is about to fall off a cliff.
In short, the practice works by borrowing stock at Price A, selling the stock on the market at Price A, and re-buying the same stock at a much lower Price B. However, this strategy is incredibly risky. Quite literally, it comes with unlimited downside risk.
In traditional investing, downside risk is equal to the value of your investment. However, with short selling, the potential for downside risk is exponentially increased, as there is no guarantee that the stock won’t shoot up in price rather than fall.
This investing strategy has repeatedly shown to outperform benchmarks and markets worldwide – in theory. While the buy and sell strategies on paper look to provide a large profit, in actuality, very few momentum funds prove excessively profitable.
The secret is that all of the buying and selling required with this strategy (actions such as day trading and shorting stocks are common in momentum investing) comes with high trading costs. For every stock traded, there is a broker or investment firm making a commission and taking their fees off the top.
Furthermore, many momentum investors spend inordinate amounts of time hawking the markets. While this is reasonable for brokers and other financial professionals, it’s not reasonable for most individuals who have to work at their day jobs outside of investing.
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