Momentum Investing: How to Ride Market Trends for Profits

Most investors are taught to buy low and sell high. But what if the most profitable path isn’t about finding undervalued stocks-it’s about riding the ones already climbing? That’s the core idea behind momentum investing: buying assets that are already going up, and getting out before they turn down. It’s not about fundamentals. It’s not about earnings reports or balance sheets. It’s about price action-and the powerful, often predictable, inertia behind it.

How Momentum Investing Actually Works

Momentum investing doesn’t guess where a stock will go. It follows where it’s already been. The strategy looks at performance over the past 3 to 12 months. If a stock has steadily climbed during that time, it’s flagged as a candidate. If it’s been falling, it’s avoided-or even shorted.

This isn’t magic. It’s backed by decades of research. In 1993, economists Narasimhan Jegadeesh and Sheridan Titman proved that stocks that outperformed over the prior year continued to do so for the next few months. Their study, published in The Journal of Finance, shook up traditional finance theory. If markets were truly efficient, past performance shouldn’t matter. But it did. And it still does.

The logic is simple: when a stock starts rising, more investors notice. They buy. More buying pushes the price higher. Others jump in, afraid of missing out. That’s herd behavior. That’s momentum. It doesn’t care if the stock is overvalued. It only cares that the trend is intact.

Most momentum investors use tools like moving averages, the Relative Strength Index (RSI), and price rate of change to spot these trends. A 200-day moving average crossing above a 50-day one? That’s a signal. A stock up 20% over six months with no major pullback? That’s a candidate. You don’t need to know why it’s rising-just that it is.

Why Momentum Beats Value in Bull Markets

Compare momentum to value investing. Value investors look for stocks trading below their intrinsic worth. They wait for the market to wake up and correct the mispricing. Momentum investors don’t wait. They ride the wave as it builds.

In strong bull markets, momentum crushes value. Think 2020 to 2021. Tech stocks like NVIDIA, Microsoft, and Amazon didn’t become winners because they were cheap. They won because demand kept rising, earnings surprised, and investors piled in. Momentum investors bought them early in the trend and held as long as the climb continued. Value investors, waiting for a pullback, often missed the biggest moves entirely.

Studies show momentum has generated annualized returns of 8-10% above the market after adjusting for risk-better than most other factors like value or quality. But here’s the catch: momentum doesn’t just outperform. It crashes harder.

The Dark Side: When Momentum Breaks

Momentum is a high-wire act. It thrives in trending markets and dies in choppy ones. The most brutal example? March 2009. During the financial crisis, momentum portfolios lost 73.42% in just three months. That wasn’t the market’s drop. That was momentum’s collapse. Stocks that had been rising for months suddenly reversed. No warning. No slow decline. Just freefall.

Why? Because momentum ignores risk. It doesn’t care if a stock is overbought. It doesn’t look at debt levels or cash flow. It only sees the chart. When sentiment flips, the entire trend unravels at once. That’s why momentum strategies have such wild drawdowns.

And then there’s the cost. Traditional momentum strategies rebalance monthly. That means buying and selling a lot. And every trade costs money-commissions, bid-ask spreads, taxes. In small-cap or illiquid stocks, those costs can eat up 2-4% of returns every year. A strategy that’s supposed to make money can end up losing it to fees.

How Smart Investors Fix Momentum

The original momentum strategy-buy the top 10% of stocks over the past 12 months, exclude the last month, hold for a month, repeat-is outdated. Too noisy. Too expensive. Too risky.

Modern approaches fix those flaws. Alpha Architect, a quantitative research firm, developed two improved versions:

• Filtered Momentum: Only buy stocks that are likely to stay in the momentum group. Skip those about to drop out. This cuts turnover by half.
• Blended Momentum: Combine recent performance with expected future momentum. It’s not just what happened-it’s what’s likely to happen next.

These tweaks reduced trading costs and smoothed out returns. Some versions boosted net returns by up to 5 percentage points per year. That’s not a small gain-it’s the difference between breaking even and making serious money.

Another innovation? Residual momentum. Instead of buying stocks just because their sector is hot, this method isolates the stock-specific trend. It filters out market-wide noise. That’s how you avoid the 2009-style crashes-when whole sectors collapsed at once.

How to Get Started

You don’t need to build your own momentum portfolio. There are ETFs designed for it.

BlackRock’s iShares MSCI World ex Australia Momentum ETF (IMTM) is one of the most accessible. It tracks global momentum stocks, caps individual holdings at 5% to avoid concentration risk, and has an expense ratio of just 0.30%. And unlike other factor ETFs, it doesn’t limit sectors. If tech is hot, it goes heavy on tech. If energy is surging, it shifts there. That’s the power of pure momentum.

Fidelity and Vanguard also offer momentum-based funds. But if you want to pick your own stocks, here’s a simple starter checklist:

1. Look at 6-12 month price performance. Focus on stocks up at least 15% with no more than a 10% pullback.
2. Check volume. Rising prices with increasing volume confirm real interest.
3. Avoid stocks with low liquidity. Bid-ask spreads over 1% are dangerous.
4. Use a 200-day moving average as your exit signal. If the price falls below it, get out.
5. Rebalance quarterly-not monthly. Less trading, lower costs, better returns.

Is Momentum Right for You?

Momentum investing isn’t for everyone. If you’re uncomfortable with volatility, if you hate watching your portfolio drop 20% in a week, walk away. This strategy demands discipline and emotional control.

But if you’re willing to ride the waves-accepting the drops as part of the ride-it can be one of the most powerful tools in your arsenal. It doesn’t predict the future. It follows the path of least resistance. And in markets, that path often leads to profit.

The key is to treat momentum like a system, not a guess. Set rules. Stick to them. Don’t fall in love with a stock just because it’s gone up. When the trend breaks, exit fast. When it starts again, re-enter. That’s how you ride momentum-not by chasing headlines, but by following data.

What’s Next for Momentum Investing?

The future of momentum is smarter, not harder. Machine learning models are now being used to detect subtle trend shifts before human traders can. Early tests show these models can improve risk-adjusted returns by 15-20%.

Institutional adoption is growing. About 65% of quantitative hedge funds now use momentum as a core factor. Global assets in momentum ETFs have surpassed $150 billion. That’s not a fad. It’s a shift.

But the debate continues. Are momentum returns a reward for taking risk? Or are they a glitch in the market’s logic-a behavioral flaw that smart investors can exploit? The answer might be both. But one thing’s clear: momentum isn’t going away. It’s evolving.