“Momentum” is one of the best kept secrets of the trading profession. If patterns and indicators tell you what actually is happening on the charts, it is momentum that tell us which charts to look at. Looking only at patterns and analyzing indicators doesn’t have much probability of success. Momentum analysis can prove to be a game changer for a trader.

But did you know that momentum can be a game changer for an investor as well? It is a single such tool that can make a huge difference in an investor’s wealth in the long run. Today’s newsletter has been written from a point of view of a investor. We will explore what momentum investing is, why it works, and how to build your own momentum investing portfolio.

Understanding the “Momentum in Momentum Investing

In the field of physics, momentum refers to the quantity of motion an object has. Or simply put, it is the rate of change of motion of an object. Higher the momentum, higher the rate of change. But in the field of finance, momentum refers to the rate of change of price.

So, it is established that momentum refers to how fast price changes. As traders and investors, we want to participate in stocks that have high momentum. i.e, stocks whose price is moving fast. Momentum investing refers to investing in stocks that have high momentum and continuously rebalancing the portfolio to stay participated in high momentum stocks.

Why momentum investing works?

The reason why momentum investing works is logical. If you are an experienced trader or investor, try to remember a stock or company that performed really well a few years back. How is that company performing now? The performance must have changed. The price is not moving as much as it did before, or the performance must have faded out.

The businesses have entered into a fast-changing environment. The trends keep changing and the companies have to reinvent themselves from time to time. It has become survival of the fittest. The company that performs well today may not perform the next year or years to come. It is wise to invest in company that can keep up with the changing trend than to stay invested in a losing stock with the hope that the price would go up later. The opportunity cost is high.

The hypothesis in this style of investing is that the improvements in a company’s fundamentals is reflected in the price and the stock that stays in momentum will continue to be in momentum until there is a deterioration in the fundamentals.

By continuously rebalancing the portfolio, the investor can ensure that the low momentum stocks are out of the portfolio and the portfolio consists of high momentum stocks.

Bring the “momentum” in investing

Let us now understand how we can incorporate this concept into the investment practice.

First and foremost, we must decide the investment universe and portfolio size. Investment universe can be readily available in the form of Indices created by Securities exchanges. The portfolio size, however, must be concentrated. Remember, we only want the stocks which are high in momentum. If the portfolio size is big, stocks with low momentum can enter the portfolio as well. Probability will then act against us rather than for us. A portfolio size of 10-20 percentile is ideal for this form of investing. Nifty 200 is used as an example for the investment universe in this newsletter. Therefore, we will rank the investment universe stocks as per momentum from high to low and invest in the top 20 stocks. The ideal weight for each stock can be equal. i.e if we choose portfolio size as 20, we must divide our total capital into 20 parts.

Second, we must define momentum for us. Momentum can be absolute or relative. Absolute momentum would be to check for the individual performance of a stock only. Relative momentum would be to compare the individual performance with the performance of the other stocks in the investment universe. Once the momentum is defined, then the stocks can be ranked.

Third, Rebalancing. Rebalancing means to check the portfolio at a set frequency and make changes if the portfolio deviates from the set rules. Because the portfolio is built for the purpose of investing, we can rebalance the portfolio every month/quarter. When the rebalancing date comes, rank the investing universe again based on your definition of momentum and then compare the top 20 stocks to your portfolio and make changes accordingly.

In this way, the investor will have created their own model momentum index. This is not a whole investment portfolio in itself but rather only a thought. You can work around the entry and exit condition.

I have explained the concept of Momentum Investing as part of TNT One.