So-called “Meme stocks” have been very much in vogue throughout 2021. Such stocks often are associated with companies that might not necessarily have strong fundamentals, but have prices that often increase without logical reason. Sometimes such increases are so exponential that they become almost comical.
GameStop might be the stereotypical Meme stock. It’s also the classic example of a Momentum Stock.
In this article, we will be looking at the concept of momentum stocks and investing. It will help us understand the different ways in which investment strategies can be shaped around stocks that exhibit trends of short-term rises. Equipped with a basic understanding of these tools, we hope to provide investors with the proper framework to analyze and identify momentum stocks. We will look at the concept behind momentum stocks, their characteristics, and potential benefits as well. So, without further ado, let us get right into it:
Definition of Momentum Stocks
You may have heard of the popular Wall Street adage: “Buy low, Sell high”. In Momentum Stocks, the phrase can be changed to: “Buy high, Sell higher”. Put plainly, Momentum Stocks refer to those Equities which have the potential of experiencing a substantial jump in price in a short period.
While the lay investor may be looking towards a long-term financial plan regarding the stock market, the same isn’t true for everyone. Some may simply be looking for an easy cash grab in the stock market without making significant investments, while others may want to take advantage of popular trends.
Additionally, for those who can afford the risk, there is a desire to obtain large sums of profit at regular intervals by taking advantage of market swings. While such an endeavor can prove highly risky, the rewards reaped are worth the effort and anxiety.
For those with the propensity to gain short-term rewards and affect a quick exit from the stock market, momentum investing is an appealing investment strategy. The goal here for these investors is to lock on gains in rising stocks and sells them when the stocks start to lose momentum. In other words, investors are already looking for stocks showing an unusually upward trend in prices, making them incredibly useful for short to medium-term profits.
However, due to the nature of these stocks, there is a need to consistently monitor the stock prices and make accurate judgments on when to sell a particular security. This makes the entire venture quite risky for the lay investor while also providing thrilling rewards for those who can afford these risks.
At the same time, if a lay investor has the proper knowledge and research about a particular momentum stock, they can temporarily enter the stock market by holding such stocks for a short period of time. This would provide the investor with a quick profit whilst also allowing them to not make any significant investments in building stock portfolios.
The risks can include entering the trade too late, selling too early, or missing out on trends that have provided massive returns. This implies that investment strategies involving momentum stocks must involve pro-active analysis and knowledge of the changing nature of industries and associated companies.
Characteristics of Momentum Stocks
In the previous section of the article, we looked at the concept of Momentum Stocks and the distinct nature of such stocks. The type of investing which utilizes Momentum Stocks aims to capitalize on the volatile nature of these stocks. The goal is to buy the stock when its momentum is on an upward trajectory and sell it when the stock begins showing signs of slowed growth or increase in value.
However, it may be quite difficult for investors to really identify a momentum stock before it becomes too late. For this reason, it is imperative that momentum investors can easily identify stocks that show the potential of being moment stocks. Hence, in this section of the article, we will explore the different characteristics of Momentum Stocks, making it easier for investors to identify one easily. It isn’t very easy to do this, but investors should use the following trends to examine if a stock can be classified as a Momentum Stock:
History of Strong Movements
If a company or institution has a recent history of making big moves on the stock market, the same will likely happen again in the future. It is possible to check monthly charts of the last two years, analyzing stock movements and trading volumes. This can help investors rely more on companies with a history of trendy stocks and volatile momentum stocks.
Additionally, strong catalysts are one of the biggest causes of the rise of momentum stocks. It is advised that investors look towards companies prone to momentous inventions and technical or regulatory developments. This could range from new technological breakthroughs to FDA approvals or Vaccine approvals.
Such occasions affect some industries more than others, depending on the economic context within which the catalyst acts. In general, however, investors should know that the digitized economy has led to massive upsurges in digital and technological services and breakthroughs. It is these breakthroughs that are breeding grounds for momentum stocks. Consequently, investors should then look towards the stocks of companies that not only have repute for momentum stocks but also are affected by the surrounding contemporary breakthroughs.
Benefits of Momentum Stocks and Investing
One of the main selling characteristics of Momentum-style investing is that large profits can be made in a short-period of time. Indeed, the profit-making potential of Momentum Stocks can be enormously large. While investors can easily make short-term profits through upward price trends, long-term gains are also possible in rare cases. The latter can provide lucrative profits, which can provide staggering levels of protection, security, and wealth to the investor who betted on the momentum stock.
However, obviously, not everyone wants such a massive amount of wealth during their investment endeavors. For this reason, it is important to note that this sort of strategy is also quite common amongst the lay investor. The reason for this being that ordinary individuals can easily bet on trends which they are aware of through social media or academic interests. It can help them make profits on a weekly or monthly basis whilst also making their investing career a temporary or short-lived one. They don’t have to make the same level of commitment required to build diversified portfolios of value and growth stocks since they can be content with a few Momentum stocks which they have taken advantage of.
Risks of Momentum Investing
We have observed what a Momentum Stock is and what its characteristics are. We also briefly touched upon the high risks that are associated with these stocks, and it is important that we pay more attention to this feature of Momentum Investing.
Understanding the risks would help investors in possessing a much wider grip over the tools required to make stock investment decisions based upon this investing strategy. It would also enable them to evaluate for themselves whether momentum investing is worth the trouble or not.
The biggest obstacle to keep aware of when it comes to Momentum Investing is the timing. If you make a move too soon, you may be put in a position where you aren’t even sure if momentum is going to take place. If you’re too late, then the trend may have aged, causing a slowdown in momentum and a decrease in shareholder returns.
It is exceptionally difficult to then steer the momentum of the train away from the wrong track, creating a scene of exponential losses for investors who have commitments within the momentum stock. It is also possible that the stock remains open overnight, becoming susceptible to external influences which cause a radical change in prices and signals in the future. These changes could range from social media trends or general mood swings, which lead to changes in stock behavior.
Another factor to consider is that of Uncle Sam – the tax man. Because momentum investing inherently involves higher turnover, short-term gains are often inherent to the strategy. As taxes subtract from the net return an investor enjoys, the tax-inefficiency of momentum investing is definitely a disadvantage of the strategy.
Lastly, the cost of being complacent is much too high when it comes to momentum investing. If the investor lets her attention diverted away from the changing trends and signals, there is a possibility that they may miss out on the opportunity to sell at a perfect time. In a world where fads and trends are changing perpetually, it is of the utmost significance for investors to stay aware and cognizant of the changes taking place around the stock market due to underlying changes.
Conclusion
In almost every way, shape, or form, momentum investing showcases itself as distinct from the conventional wisdom of investment strategies. Momentum Stocks demand disciplined attention and are relatively less cost-effective.
The latter is the case due to the extreme risks that are associated with investing in momentum stocks and the commissions payable to them. These risks are inherent within the momentum stock owing to its volatile and irrational nature.
Additionally, investors must also be aware of the luck factor that is rooted within this investment strategy. Unforeseen social media fads or trends can also contribute to irregular changes in the value of the momentum stock. For this reason, it is imperative that investors think long and hard before riding the wave of momentum stocks.
At the end of the day, like many things associated with investing, following the herd – which momentum investing ultimately does – is not necessarily the best ingredient for long-term financial success. While momentum investing can have a place in some portfolios, we shy away from that approach and focus on the tried-and-true methods of allocating capital to those traditional factors which have been academically shown to produce excess returns such as value, dividend-growth, and quality stocks.
September 17, 2021
RVW Wealth