How to Invest in Momentum Stocks and ETFs

As an investor, you’ve likely heard the phrase, “Buy low, sell high.” But what about, “Buy high, sell higher?” That’s the basic premise of momentum investing. It's a data-driven investment strategy for traders seeking to capitalize on improperly valued equities. The goal is to buy high, sell at peak profit, and rid your portfolio of unwieldy money. Sappers as soon as possible.

🤔 Understanding momentum investing

Momentum investing is one of the more technical trading strategies. It involves seeking out securities that under- or overperform against the broader market. The goal is to determine a security or fund’s price momentum and capitalize on continuing trends with certain indicators:

• Trend lines: lines drawn between two points on a price chart to determine a stock’s overall direction
• Moving averages: lines that enables traders to determine a stock’s overall movement while minimizing background noise from small, ultimately insignificant fluctuations
• The Average Directional Index (ADX): a popular momentum indicator that calculates the expansion or contraction of a security’s price range over time to determine the existence and strength of a trend

How does momentum investing work?

As a rule, momentum investors seek to rack up profits in short-term increments, rather than in the long haul. For instance, an investor may hold a stock for anywhere from 2 months to 3 years before selling. That's compared to a long-term investor who may hold the same security for 2-3 decades or more.

Ideally, an investor will see long-term profits with a momentum strategy by augmenting their portfolio with high-performing securities as they rise, then selling them off when they start to lose value.

This approach assumes that investors over- or undervalue certain stocks, leaving room for investors to profit off price discrepancies. Instead of selling your highest-performing securities, you buy more of them, while selling off any assets that drop in price.   

Momentum investing rejects the efficient-market hypothesis (EMH), which states that assets are accurately priced according to all available information. Instead, investors believe that growth stocks will continue to grow, while consistently losing stocks will continue to lose.

What this means for you

If you want to adopt a momentum investing strategy – or just a few momentum securities into your portfolio – getting started with your current portfolio is fairly simple:

• Pick a time frame, such as three to six months or a year
• Assess the performance of the stocks you own over that time
• Sell the lowest performers at the end of your chosen time frame
• Invest more in the stocks that have seen high returns

Note that there is a significant difference in time cost (and real cost) between investing in momentum stocks and momentum ETFs. Maximizing your stock investment returns requires more research, more trades, and a constant finger on the market’s pulse.

But for more casual momentum investors, a generalized momentum philosophy can still generate returns that match (or exceed) standard indices. A less granular approach – such as investing in momentum ETFs or throwing money in when the overall market is performing well – allows you to benefit from positive volatility without sacrificing your weekends to watching the stock market.