What is a momentum investor?

A momentum investor believes in the saying ‘the trend is your friend’. He or she will capitalise on the energy of the market by buying stocks when they’re on the up, and selling them when they go up even further.

Momentum investors work on the assumption that most people are slow to react to information, are hesitant to sell bad shares, hold on to existing shares for too long and, generally, follow the herd, thus driving existing trends further. All of these factors can be used to make money.

To make money a momentum investor has to be utterly ruthless with their trades – they won’t think twice about getting rid of losing shares to free up capital to pump into their winning shares, and all the time they’re thinking two or three moves ahead, jumping from peak to peak and trying to lead the pack.

It could be argued that with value investing and growth investing, the investor isn’t just putting money into a business but is also providing some sort of social good – providing jobs, encouraging investment and growth, thus helping to keep the economy spinning… but momentum investing eschews all of that. It’s short-term, cynical, exploitative and only interested in the bottom line. These are elements that make a lot of people wince, especially since 2008, and this may play into the reason for momentum investing not enjoying the best of reputations. Add in the fact that the language used around momentum investing makes it sound like a get-rich-quick scam and that a lot of momentum investors subscribe to a rigid rule set they develop themselves and you’ve got a powerful brew that will have most holding their nose.

But momentum investing works for some people. And it’s nothing new. It was developed in 1920s America, and those smart enough to read the market and knew when to get out – one of the keys to momentum investing is understanding and acting on the knowledge that everything can suddenly flip upside-down and go the other way – made some serious money. Heady names in the investment world have produced studies that show how certain momentum strategies make money no matter what the economic conditions.

How to do it – some practical tips

One strategy would be to run a ‘blue-chip’ momentum portfolio based on the FTSE 100 index of the biggest companies listed on the London Stock Exchange. You buy the top 10 stocks in the FTSE 100 of the last 3 months, hold them for them for the same amount of time and then do it again. This will, however, incur a lot of trading fees so you need to be sure that it’s going to work and you can put in the required time and effort.

To cut out the dealing fees, you could buy an exchange traded fund that follows a momentum strategy. This means you just have to buy the one fund and all the trades are done within the fund for you. One example is the iShares Edge MSCI World Momentum Factor UCITS ETF. This offers investors global exposure to shares with a focus on stocks that have been experiencing an upward price trend.

If you’re more inclined to invest in open-ended funds such as unit trusts and oeics, then you can participate in momentum investing too.

FundExpert.co.uk, an online initiative of Dennehy Weller & Co, independent financial advisers, runs a dynamic fund selection process which gives open-ended funds “momentum ratings” of one to five stars. It says a five-star momentum rating should mean a high probability of extra growth. There is no charge to view the service.

Salty Dog Investor is an interesting company, although unregulated. For £25 a month it will send you two newsletters a week which give you a market overview and identify changes that the company is about to make to their portfolios, of which they have two. You are, of course, free to follow their moves with your own portfolios. You also get access to all kinds of fund data and guides as well as a monthly print newsletter. You can read regular updates on Salty Dog’s investment strategy in Moneywise’s sister title, Money Observer.

Moneywise verdict:

The very idea of momentum investing goes against everything all those wealthy, whisker-sporting ye olde world gentlemen who gaze out from the pages of the glossy investment company brochures believed.  It’s riskier than a certain board game of global domination and requires monk-like levels of commitment. However, a momentum investor can make staggering amounts of money, and very quickly. But it’s not something you can just fiddle with in the evenings: you’ll need a deep knowledge of the markets, access to a newswire and trading platform, enough starting capital to make trading fees irrelevant, public school-bred confidence, plenty of luck and more fee time than any reasonable person has the right to expect.

But that’s not to write it off completely. No investment strategies are mutually exclusive; you can mix them up to your heat’s content. So if you’ve got a bit of spare cash lying around that you’re willing to lose and you fancy a challenge, why not try a bit of momentum investing?

This is the final entry in this short series on the different types of investor. Make sure you're up to speed with the first, 'What is a value investor?' and the second, 'What is a growth investor?'