Momentum Investing: How To Manage Risk? - smallcase (2024)

Momentum investing is a strategy that seeks to capitalise on the prevailing market trends to beat the market. However, as with any investment approach, the potential for high returns comes hand in hand with increased risk. Successful momentum investing demands not only an eye for identifying trends but also a robust risk management framework to navigate the volatility inherent in this strategy. In this blog, we will unveil a few risk management tips for investors picking stocks using the momentum factor.

What is momentum investing?

This strategy is based on the idea that past performance of a stock’s price is a good predictor of future performance, i.e. stocks that have recently performed well are expected to perform well in the future. No matter whether it’s a downward trend or an upward trend, the trend is likely to persist for a long time.

There are several different ways to implement a momentum investing strategy. Some investors simply buy the stocks that have outperformed the market in the last three to twelve months. Others use technical indicators or quantitative models to identify stocks that are showing signs of momentum.

Why does the momentum strategy work?

The philosophy behind the momentum strategy can be attributed to our natural tendency to follow others and our fear of missing out. Further, momentum can be self-reinforcing. When a stock is rising, investors are more likely to buy it, which can further drive up the price. This can create a self-reinforcing cycle that can keep the stock price rising for a long period.

Risks of momentum strategy

Systematic risk

It is the risk that the overall market can decline, regardless of the performance of individual stocks. This is the most significant risk for any investment strategy, including momentum investing.

For example, consider the COVID-19 crisis, which caused the overall market to crash for a short period. If you were investing during the time, the stocks in your portfolio would have likely declined regardless of their past momentum. This is because the market risk outweighed the momentum effect. This type of risk is out of control for most investors and cannot be eliminated.

Unsystematic risk

It is the risk that is unique to a particular stock or industry. If your investment portfolio only consists of high-momentum stocks from one sector, the chance of losing money goes up if an industry-wide event or news causes a decline in stock prices.

For example, the automobile industry was facing a shortage of semiconductors, which are used in electronic components such as chips and transistors, due to the COVID-19 pandemic and the war in Ukraine. The shortage of semiconductors was causing production delays and price increases for automobile manufacturers. Such an event could potentially affect the stock prices of automobile companies. This type of risk can be reduced by diversifying your portfolio to include stocks from various sectors or industries since it’s unlikely that several industries will be affected by the same event.

Single factor risk

Market downturns often bring about abrupt changes in investor sentiment. Stocks or assets that were previously exhibiting strong momentum can experience sudden reversals as dynamics shift. Hence, during market downturns, a momentum strategy can underperform the market.

To reduce your risk of solely relying on momentum, opt for a portfolio that takes into account various factors. Multi-factor portfolios choose stocks based on factors like momentum, low volatility, quality, value, and more. By not solely depending on momentum, these portfolios aim for consistent long-term gains.

For example, consider a portfolio that has stocks with high momentum and also some allocation towards low-volatility assets like bonds or safe-haven assets like gold, which aren’t too susceptible to market fluctuation. This approach avoids putting all your eggs in one basket, thereby mitigating the risk of relying on a single factor. Multi-factor and multi-asset strategies have the potential to yield more consistent and stable growth over the long haul.

Other tactical risk management techniques

1. Position sizing –This involves determining how much of your portfolio’s capital to allocate to each stock, allowing you to limit the potential losses from any single stock that experiences a reversal in its momentum trend. By allocating a smaller portion of your portfolio to riskier momentum positions, you can protect yourself from significant losses while still participating in the potential upside.
2. Using stop losses– Stop losses allow investors to set a specific “exit point” for each position, ensuring that if a stock’s price falls below that level, the position is automatically sold. In momentum investing, where trends can change rapidly, stopping losses can help investors preserve capital and manage risk by providing a disciplined approach to cutting losses and moving on to the next opportunity.
3. Gradual entry and exit– Rather than going all-in on stock at once, consider entering and exiting positions gradually. Gradual entry involves buying a stock in increments over time. This allows you to test the waters before committing a significant portion of your portfolio to the stock. If the stock price declines after you buy it, you can always sell some of your shares and reduce your losses. Similarly, scaling out of a position in increments can help you lock in profits while still allowing for potential further gains.
4. Rebalancing– Momentum strategies can lead to certain stocks becoming a significant portion of your portfolio due to their strong performance. Regularly rebalancing your portfolio involves selling off a portion of stocks that have grown disproportionately and reallocating funds to stocks that may have the potential for high momentum. This helps maintain a balanced portfolio and prevents overexposure to specific stocks.

The takeaway

Momentum investing can lead to strong gains, but investors need to have realistic expectations. Not all momentum plays will result in significant profits, and some might even lead to losses. Setting realistic goals and understanding that not every stock will be a winner can help you manage emotional reactions to market fluctuations.

Remember that no risk management technique can eliminate the risks associated with investing, especially in strategies like momentum investing. These techniques are meant to help you mitigate and navigate risks while taking advantage of potential opportunities.

Disclaimer:The content in this article is purely the author’s personal opinion and is for informational and educational purposes only. It should not be construed as professional financial advice and nor be construed as an offer to buy/sell or the solicitation of an offer to buy/sell any security or financial products.