Question

6. Is it important to know the economic explanations of a profitable investment strategy? In other words, why not just simply invest in some ideas like momentum and make money without caring too much about its underlying reasons? (2)

Answer 1

Here are my views about Momentum

Every investor no matter the level of individual skill is familiar with the adage “buy low and sell high,” as the golden rule of successful investing. The concept of purchasing securities at a low price and profiting from the rise in share price is what many consider to be the true way to make money in the stock market.

This strategy seems so simple until you consider the pit falls you may encounter along the way that could prevent you from maximizing your investment gains. Perhaps the biggest threat to this strategy could be the role that emotions play in executing this investment plan.

In order to “buy low and sell high” an investor must be willing to buy when everyone else is selling. It is important to remember that this will inevitably be more difficult than it sounds. The tendency to believe that everyone else knows more than you do, combined with what would surely be an immediate loss of money if the stock is still trending downward could cause a spike in fear that could make an investor act irrationally and deviate from their investment plans.

In momentum investing, investors attempt to profit from a security that is currently rising in price. Relying on positive momentum in a stock, momentum investors do not look for shares that are a good price, but rather rely on upward trends to profit in a trade.

HOW TO MAKE MOMENTUM INVESTING WORK FOR YOU

Contrary to popular belief, the greatest risk to your investment strategy is actually not falling share prices, it is making investment decisions based on fear and/or greed. A trading strategy that actually factors in losses (an inevitable fact of investing – you will have losing trades) can help you avoid irrational decisions and stick with your plan of action.

Momentum investing is a strategy that is based on “buying high and selling higher”, and can serve to help investors profit from a stock that is in an upward trend. An investor must first identify a security whose price is rising, enter into a trade, and then sell the security as the price continues to rise.

There are several key factors to successful momentum investing, and this strategy requires a commitment to research and detailed stock analysis. It is important for momentum investors to consider many things when choosing which security to purchase including strong upside volume, consistent revenue growth, high relative strength over a 12 month period relative to the market, and a good return on equity from the company.

Momentum investing requires than an investor act quickly, entering into a trade when the time comes and exiting a position equally as fast. As a momentum investor is looking for fast growth, there is no time to purchase a security that does not have stable increases in share prices.

With a strategy of momentum investing, the key is not knowing when to buy as with traditional “buy low sell high” investing, it is knowing the right time to sell a security. A momentum investor must act swiftly when it comes time to sell to lock in profits and prevent losses.

WHAT TO LOOK FOR IN A MOMENTUM STOCK

With momentum investing, an investor must be on the look out for any bad news concerning their security including any downside guidance concerning revenue or earnings. Successful momentum investing involves identifying securities with growth, and anything that indicates otherwise is a signal to sell.

As with every investing strategy, there are real drawbacks that need to be considered before implementing this type of play on rising stock prices. Momentum investing requires a commitment to researching every security thoroughly, a time consuming process that may not be suitable for every type of investor.

You will also be paying a premium for a stock as a momentum investor, and this can make it difficult for smaller investors to take a large position in a security. You must also be prepared to exit a position quickly, and you may find that it is a challenge to admit that you were wrong after all of your research. It is important to remember not to let emotion keep you in a losing investment

DRAWBACKS TO MOMENTUM INVESTING

There is also the very real possibility with momentum investing that you could be entering into a trade at the top of the stock’s price range. While nobody wants to be the person who is left holding the bag at the very top of a stock’s price, this scenario most appropriately illustrates the importance of have an exit strategy in place prior to embarking on a momentum investing play.

Perhaps the greatest tools in a momentum investor’s arsenal are the stop-loss and trailing-stop order. These tools make it possible to automate your investment strategy, thereby insuring success on two levels. The first is that by using these automated orders you virtually guarantee that you will stick to your trading plan. Sell orders are triggered automatically by a share’s price, which you determine at the onset of a trade.

An additional benefit to using these orders is that you will not be required to monitor your positions constantly. For many people, it is not realistic to sit in front of their trading screen during market hours monitoring every tick of a stock’s price.

Automating your order with stop-loss and trailing-stop orders means that you can go about your day, and your trading plan will automatically be executed if your security reaches your predetermined parameters. These orders are also not without their drawbacks and investors should weigh their pros and cons carefully prior to utilizing this strategy.