A classic Wall Street maxim is "buy low and sell high" which characterizes value investing. While this is easy to say, it's much harder to apply, since assets priced "low" can get cheaper or stay low for long periods. Momentum investing sidesteps this issue by focusing on assets that are already performing well in terms of price and fundamentals. Probably, it means the asset is no longer cheap.
Selecting What to Buy
Someone looking to buy low must be judicious in selecting the right asset. Momentum investing lets the market dictate what it should buy, although different investors may differ on exact criteria. Some momentum players may look to buy the stock which is up the most over the past month or week, while others may focus on the stocks delivering the highest amount of earnings or revenue increase. Another version is to buy a stock in an uptrend with the hope that a catalyst like earnings or announcement will lead to even more gains.
Momentum stocks tend to be expensive by traditional valuation metrics. Often, they are not profitable but growing sales at a rapid pace. Buyers in the stock are not necessarily buying due to the fundamentals but the hope that they can unload it for a higher price down the line.
Buy High, Sell Higher
Thus, momentum investing's maxim is "buy high and sell higher". To properly apply it, one must sell losers and add to winners. And it tends to be applied in a shorter timeframe than its inverse strategy - value investing. While value investors are looking to run away from the herd in a contrarian manner, momentum investors want to be on the leading edge of the herd. The goal is to ride a position to the top, and exit right before it's turning.
When the turn comes, it can be brutal. The common adage is that "stocks take the stairs higher and the elevator lower". During the 1999-2000 tech bubble, many momentum stocks were down more than 80% in a matter of weeks when the market crashed. Mark Minervini's research suggests that 80% of momentum stocks lose 50% of their value from peak valuation, and 50% of momentum stocks lose 80% of their value from their peak.
Cutting Losses and Sizing Positions
Therefore, an important element of momentum investing is to cut your losers and appropriately size your positions. This means not taking an undue risk on any single position and setting some sort of stop loss. A stop-loss means a position will be sold if it goes under some predetermined level. For example, a position would be cut if it goes down more than 10%.
