Last time we talked about value investing, which is based on the Firm Foundation Theory. Today we’ll talk about momentum investing. It is based upon what it known as the “Castles in the Clouds” idea.
The idea behind momentum investing is that stocks that are going up tend to keep going up, and vice-versa, just like an object that has momentum will tend to keep moving. The reason this occurs for stocks is human nature. If people see that a stock is going up, they start to believe that it will continue to go up, just because it has gone up. This was seen in houses during the 2003-2007 period where individuals started paying well over offer prices for houses, taking out adjustable mortgages they could not afford to pay when the interest rates reset within a few years. They did not worry about this because the house price had doubled in price during the last few years, so they expected someone else to come along who was willing to pay double what they paid in a few years.
The Greater Idiot Theory comes into play here….
As the name Castle in the Clouds implies, there is little if any basis for the prices being paid; the gains are being built on weak substance. This is a game of chicken, or greater idiot theory, where you purchase a stock–not concerned about the value of the shares–because you expect to be able to find a greater idiot who will pay even more for the shares. You just need to make sure you are not the one who ends up holding the bag because, as you can see from the housing bubble burst, things don’t end pretty when prices fall back to earth. It’s not good to be the greatest idiot! Usually prices fall even below fair value when they do come down because, just as people buy regardless of price on the way up(attracted by the potential for a quick profit), people want to get out regardless of the price on the way down (because they’re scared they’ll lose even more). (Note, this is where great opportunities arise for value investors.)
Because of this type of behavior, stocks tend to go up and stay up longer than a value investor would expect them to, and likewise stocks tend to stay down longer than expected. You should keep this in mind when wondering why the great stock you picked is languishing – it may just be that people aren’t buying it because people aren’t buying it.
Fast rewards, but danger abounds….
This type of investing has the advantage over value investing that the rewards tend to come faster. Because the stock is already on the way up, it will tend to continue up right after you’ve bought it. The disadvantage is that you can’t stay in the position as long as you could if you bought a stock which was growing steadily because eventually the stock will run out of greater idiots and crash back down. For examples of these types of stocks, see Krispy Kreme and Outback Steakhouse. This will mean that you will be taking profits more often, so taxes will be higher than with the core method proposed by this blog. There is also a greater risk of loss than with value investing since you will tend to be buying at high prices, rather than low prices.
Finding stocks for momentum buying is easy, as it was with value investing. A good place to look is the new 52-week highs list published in most newspapers. Also looking at what stocks analysts are touting on CNBC, finding the “Wall Street Darlings,” works. Try to find stocks that are increasing rapidly in their long-term trends (look at a chart about 1-year long, and find stocks that have been increasing rapidly for at least a few months). Note that we’re looking for something that is increasing rapidly over months, the long-term trend, rather than just a few weeks or days. Short-term moves are too difficult to time and don’t go far.
Earnings should also be growing rapidly. Remember to get in early, however, since when it ends, it ends. A good rule-of-thumb is if the stock fails to reach a new high after a dip, it is time to get out. I’ll talk a bit more about technical analysis on a later post which will be helpful in assessing these types of situations.
When to maybe use momentum investing.
I might use momentum investing when I have a relatively short period of time – say a couple of years – before I’ll need the money I’m investing, and it wouldn’t be a great tragedy if things didn’t work out. For example, if I have an amply funded vacation fund and I’m planning a trip in a year or two, I might use a portion of the money to buy a couple of stocks that are going up rapidly. If things work out and they go up 10-20% over the next few months to a year, I’ll cash out and have some extra cash to either enhance the vacation or save for the next one. If things don’t work out, I’ll cash out anyway and then take a smaller vacation or find funds elsewhere to use. By choosing stocks that have momentum, I’m more likely to do well over the near future. If I really need the money, however, I would stay in cash and not take the risk.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.