We hear a lot of so-called Wall Street experts talking about momentum stocks in various settings. We want to make sure you understand the concept of momentum investing and how you can profit from it during your investing journey.
Most investing literature suggests that you buy stocks at a low price and sell when the price gets too high. This creates the well-known Wall Street phrase of “buy low, sell high”.
Momentum investors look for stocks that for some reason have started to increase in price (but are not necessarily low priced) and buys them. Stocks can start to take off for many reasons, such as:
Momentum investors will then hold that stock until its price starts to plateau, at which time they will sell them.
Momentum investors still fall loosely into the “buy low, sell high” concept, but a better way to describe momentum investors is “buy when the price starts to rise and sell when the price starts to plateau”.
Momentum investing is not for everyone. Here are some characteristics that describe a momentum investor to help you determine if this is right for you:
An Example of a Momentum Stock
Let’s take a look at a historical chart of a momentum stock to see when a momentum investor might have gotten into and out of a position in that company. See our example of Tesla below.
Remember successful momentum investors are looking for outsized price movements in the stocks of the companies they are investing in. Few large capitalization stocks have been more volatile than Tesla (ticker TSLA) the last couple of years.
After many years of great ideas, but mediocre stock market returns, Tesla’s business and stock price started to catch fire in early 2020 despite the impact of the pandemic. With Tesla’s stock price moving so quickly to the upside it no doubt caught the attention of many momentum investors. Remember momentum investors are not trying to catch an exact bottom in a stock, but instead they are looking to invest in stocks that are starting to show signs of significant positive price movements ahead.
So momentum investors likely got into Tesla in the $300 to $400 range when the stock had already started to appreciate a good bit. Tesla’s stock price peaked at $900 before starting to retreat to its current price below $600.
Now this is where momentum investors really need to be careful. A momentum investor can not fall in love with a stock. Once the momentum of the positive price movement starts to stop, you need to sell the stock. That does not mean you will get out of the stock at the top, but most momentum investors had exited the stock by the $750 to $800 range, saving themselves from significant additional downside and related losses as the Tesla stock price continued down below $600 a share.
A movement out of momentum stocks and into sectors like value stocks can happen all at once. That is why it’s important for retail investors to pay close attention to the market and movement of their stocks.
We here at Wealthplicity are big fans of Vanguard for managing portions of our investment funds. Vanguard is a huge and highly respected company that has trillions of dollars under management. They are also well-known for their low expense fees charged to mutual funds and ETFs.
Vanguard has an ETF geared towards momentum investing called Vanguard U.S. Momentum Factor ETF (ticker VFMO). While it has only been around since the end of 2017 it has performed quite well.
To manage this ETF, Vanguard “uses a rules-based quantitative model to evaluate U.S. common stocks”. The ETF “invests in stocks with strong recent performance”. In other words, invest in a hot stock until it is no longer hot, and then switch to the next hot stock.
It has averaged a 19% annual return over each of the last three years, which is quite good.
It’s top five holdings as of April 30, 2021 include Tesla, Deere, Capital One, Apple and Square, so you can see they are investing in innovative and well-known companies. No high-risk penny stocks here.\
There are always stocks that are outperforming the market averages. A year ago, it was the “stay at home stocks” like Zoom and Peloton. For the second half of 2020 it was innovative stocks like electric car companies like Tesla and Nio. More recently airline and cruise ship stocks that are “reopening stocks” have outperformed because of the COVID vaccine.
You can find out about these stocks by reading or listening to financial news, or looking at the stocks that are making new 52 week highs each week. More sophisticated momentum investors will have algorithms set up to spot these stocks more quickly.
As an example of a current momentum stock, look at a company like Upstart Holdings (ticker UPST). With a $9 billion market capitalization they are substantial.
Upstart is “an artificial intelligence-based lending platform that partners with banks to provide personal loans using non-traditional variables, such as education and employment, to predict creditworthiness.”
Upstart’s stock has gone from about $50 a share at the beginning of 2021 to about $119 a share today. Given the price movement for Upstart has been so much better than the overall market, Upstart easily qualifies as a momentum stock. Investing in Upstart today would be a great example of buying into a momentum stock at a high price, hoping that investors will take it higher in the months ahead.
But if you invest in Upstart (as an example of a momentum stock), do not fall in love with it. Be ready to sell if the price momentum starts to plateau or reverse.
Summary
Momentum investing is not right for all investors and should only be used by more advanced investors.
In some ways, momentum investing is the opposite of “buy and hold”. The idea is to hold the stock for as long as it has the hot hand, and then move on to the next hot stock.
If you are going to use momentum investing be sure to think about whether you want to own a mutual fund/ ETF, or if you have the time/skill to pick individual stocks.
And when it comes to momentum investing, or any kind of investing, be sure to only invest in high quality stocks with a substantial market capitalization of a couple billion or higher. Never invest in penny stocks.
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