De-jargoned: Momentum investing
It means buying stocks that have been rising in the recent times and selling underperformers
The Indian stock market is trading at all-time high levels and has gone up by 7% since the beginning of 2014. There are different explanations for this rise. Some experts argue that it is because the macroeconomic condition has improved in recent months, while others take a view that markets are going up on the expectation that a new business-friendly government is likely to take office after the general elections. So, should you buy stocks simply because the market is going up? The answer will depend on the style of your investing, as there are investors who like to play the momentum.
What is it?
Momentum investing basically means buying stocks that have been rising in the recent times and selling underperformers. The basic idea behind following this strategy is that stocks that have gained recently will continue to do so in the near term, while stocks that have underperformed, will continue to lag.
For and against
Various arguments are given in the favour of momentum investing. For example, investors will be buying winners and they will be able to avoid a crash by selling stocks that are falling.
However, the strategy is debatable as it is not always possible to beat the market by picking stocks that have done well in the past. There could be different reasons for the spike in the price of a particular stock which may quickly fizzle out or even reverse in the short to medium term.
Momentum investing is against the efficient market hypothesis, which basically says that all the information available is in the price and it is not possible to predict the future movement.
Interestingly, Eugene F. Fama, who shared the Nobel Prize in economics with Robert Shiller and Lars Peter Hansen in 2013, and is also known as the father of efficient market hypothesis, found in a study that there is momentum effect in the market. In a paper (Size, Value, and Momentum in International Stock Returns, 2012), Fama, along with Kenneth R. French, said, “… Except for Japan, there is return momentum everywhere, and spreads in average momentum returns also decrease from smaller to bigger stocks."
What should you do?
While the research shows that there is momentum in the market and some investors can increase returns by following the strategy, things can be tricky in the marketplace and retail investors may find it difficult to follow. Also, since the effect is higher in small stocks, the risk is higher for small investors. Therefore, it is advisable that investors pick stocks on the basis of the strength of the business and not necessarily because the price is rising in the marketplace.
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