How does investor psychology influence momentum investing strategies?

There is optimism galore, the markets are buzzing with initial public offerings (IPOs) as companies seek to raise funds from the public. Meanwhile, hopeful and confident investors, driven by optimism and confidence, are eagerly applying for these opportunities.

Recent data from the Association of Mutual Funds in India (AMFI) underscores the significant growth of India’s mutual fund industry over the past year. The assets under management (AUM) have seen substantial growth over the last five years, fuelled by factors such as rising disposable incomes, heightened awareness of mutual funds, and robust performance in the equity market.

Momentum investing has gained popularity recently, especially in the current bullish market. The strategy revolves around capitalizing on upward trends, which can prove highly profitable in an optimistic market environment. It primarily targets short-term gains, making it appealing to investors looking for quick returns.

Understanding the mentality driving momentum investing

Momentum investing involves purchasing assets, usually stocks, that are currently experiencing upward price movements and selling them as these trends begin to lose momentum. The strategy aims to capitalize on the ongoing rise in stock prices to generate profits.

Momentum is unpredictable, and many trends can lose steam rapidly. Momentum investing typically requires frequent buying and selling, which can increase portfolio volatility. So, what motivates investors to join this unpredictable journey, which may not always be smooth but can involve rough patches when markets face turbulence from sudden rumors or corrections due to unexpected news?

At its essence, momentum investing operates under the premise that trends in the short term tend to continue. Therefore, a stock that has been rising is expected to continue rising, while a stock that has been declining is expected to continue declining. At the heart of every extended bull market, one finds momentum investors who focus on stocks that have demonstrated significant gains in recent periods, such as the past few months or even a year.

These investors frequently utilize technical indicators—charts and mathematical formulas—to analyze past price movements and predict future trends. Long-term investors generally do not engage in this rapid strategy, which involves quick buying and selling to capitalize on short-term gains. Momentum investing is fundamentally influenced by psychology. The strategy hinges on the belief that investor sentiment can magnify trends. As a stock price climbs, more investors may join in, further pushing up the price (FOMO – fear of missing out) based on this momentum.

Realizing the duality of risk and reward

Investor enthusiasm occasionally drives stock prices above their intrinsic worth. Momentum investing offers both potential rewards and risks. Despite bullish markets, downturns can still occur. There’s no assurance that past top performers will maintain their momentum. Momentum strategies, characterized by frequent trading, can increase portfolio volatility. A stock that has been rapidly rising could suddenly reverse course, resulting in unforeseen losses. Even in a bullish market, downturns can occur unexpectedly. Momentum funds, which typically focus on stocks that have recently shown strong performance, may be particularly susceptible during market corrections.

Momentum investing offers opportunities to capitalize on short-term trends, yet it’s not a failsafe strategy. Incorporating momentum stocks into a smaller, “satellite” segment of your portfolio can diversify and potentially enhance returns, but they should not constitute the core holding. The performance of momentum stocks should contribute positively to overall portfolio growth. If they fail to enhance your objectives or hinder progress, they may not be suitable for inclusion. Each holding in a well-diversified portfolio should serve a distinct purpose. Momentum stocks that do not contribute positively may only introduce unnecessary complexity.