Momentum investing strategy: can it really give you an edge?

A Surprising Trend That Defies Conventional Wisdom

Dec 31, 2024

What if the strategy you have been overlooking is the very one that can boost your returns when markets hit turbulent patches? Many market participants focus on bargain-hunting or long-term fundamentals, yet there is a growing number of traders who swear by momentum investing strategy. Their argument is simple: instead of searching for dormant stocks, why not jump aboard the trains already in motion? In practice, momentum means buying assets that are rising and selling (or shorting) those in decline, based on the premise that yesterday’s winners often keep winning—at least for a while. Sceptics claim such tactics are merely gambling, pointing out that market reversals can trap momentum traders in painful losses. Believers counter by noting long spans in which uptrends persist, letting them ride surges for significant profit.

To see why momentum holds so much allure, look at episodes where certain stocks soared for months before cooling off. Technology shares during the late 1990s exemplified this pattern. They did not just float higher; they rocketed upward in a frenzy of speculation. A classic view might have insisted on waiting for valuations to revert to sober levels, but momentum traders who jumped in earlier were handsomely rewarded as share prices sprinted ahead. Of course, the dot-com bust around 2000 left some bag-holders when the market finally rolled over. Yet many momentum followers had already sold by that point, using technical triggers that told them to exit as soon as the tide turned. They often avoided the worst of the carnage by refusing to hold on once the upward push began to fade.

Another sighting of momentum at work emerged before the 2008 financial crisis. Commodities such as oil and gold rallied ferociously, partly fed by global sentiment about unstoppable growth. Momentum investors charged in as prices gained speed, hitting peak after peak. When signs of economic trouble finally broke into mainstream headlines, these momentum players watched for signals to exit quickly, often leaving slower-moving portfolios to suffer the brunt of the reversal. Momentum, then, can be described as harnessing crowd tendencies—buying on strength and cutting losses when evidence of reversal appears. Yet this approach also hinges on deeper layers: mass psychology, behavioural traps, and the powerful signals found in technical analysis. Far from being a simplistic method, momentum investing strategy draws from the interplay of collective sentiment, patterns on the charts, and emotional biases that govern human trading decisions.

Mass Psychology and the Lure of Joining a Winning Team

Momentum strategies thrive in markets where people tend to chase winners and shun losers. Consider how investors react when they see a stock up 20% in a short span: many want to get involved, fearing they will miss out if the rally continues. This fear of missing out bolsters upward price moves, which in turn draws in more buyers, creating a self-reinforcing loop. On the other extreme, a stock dropping fast induces panic, fuelling further selling. Mass psychology—often steered by group emotion rather than cool logic—becomes the fuel for these prolonged price swings.

If a crash looms, many participants do not realise the severity until share prices have already slid. During 2008, plenty of market watchers remained convinced of a quick rebound, even as financial institutions started showing cracks. Those who practised momentum strategies were often first out the door, citing clear signs that price trends had reversed. When banks like Lehman Brothers collapsed, it was not a mild correction; it was a full-blown rout. People caught unprepared scrambled to sell, crushing prices in a brutal downward spiral. But the momentum crowd, having observed distribution patterns and intensifying weakness, typically exited well before the crowd fully grasped the scope of the disaster.

Human beings have a natural inclination to follow the pack, whether times are good or bad. This explains why markets frequently overshoot on both upside and downside movements. The urge to imitate others often overwhelms rational judgment. From the South Sea Bubble of the 18th century to the dot-com mania, mass euphoria fuels upward spirals until a breaking point. Momentum strategies effectively capture these stretches of crowd enthusiasm, but they also rely on strict risk management to avoid huge losses when the tide reverses. While critics label momentum as chasing ephemeral trends, its core principle is to capitalise on the swarm mentality that characterises markets, especially during times of extreme optimism or dread. The trick is to recognise when that tide turns, and that is where behavioural finance insights can help separate a methodical plan from blind chasing.

Behavioural Finance and the Power of Herds

At first glance, it may seem puzzling that large groups of intelligent people can collectively misprice stocks, driving them much higher or lower than basic fundamentals might suggest. Behavioural finance points to ingrained biases like overconfidence, anchoring, and confirmation bias. Overconfidence prompts traders to double down on assets that have already risen sharply, convinced that rising prices validate their skill. Anchoring causes individuals to fixate on certain figures—such as a recent high or a well-publicised target price—and cling to them despite changing conditions. Confirmation bias means we seek out information that supports our existing view while disregarding critical signals to the contrary.

These tendencies feed momentum. When prices rise, overconfident traders attribute this to their own investing genius, ignoring cautionary remarks from naysayers. They anchor to new highs, feeling a sense of triumph. Others, witnessing these gains, jump aboard out of fear that they are missing an easy ride. Effects compound, turning a modest rally into a runaway move. This process also shapes the flip side. Once the market sours, investors may hang on too long, convinced it is a temporary dip. As panic deepens, fear takes hold, prompting a stampede for the exits, which drives the downward spiral. Momentum traders, however, lean on signals that something fundamental in the trend has shifted, aiming to exit before the worst of a crash.

Behavioural finance does not merely highlight why markets get irrational. It also shows how certain techniques can guide decisions when everyone else is acting emotionally. For instance, systematically trailing stop orders behind winning trades can force an exit when the trend breaks. Psychologically, that step becomes easier if you accept that markets move in waves and a reversal is natural after a big upswing. Similarly, rebalancing portfolios regularly can lock in some profits from momentum plays, preventing overconfidence from trapping you in an eventual collapse. The heart of a momentum investing strategy, then, is not to cling blindly to trend-chasing but to remain vigilant about signals that the surge is exhausted. By integrating these principles from behavioural finance, momentum traders can offset the emotional traps that ensnare many.

Technical Analysis and the Clues of Price Trends

Momentum cannot flourish without observable cues on a price chart. Although critics sometimes dismiss technical analysis as tea-leaf reading, decades of data suggest that certain patterns repeat because they mirror human habits in markets. A rising price channel, supported by increasing volume, can signify a valid uptrend. Meanwhile, a sudden divergence—where the stock’s price continues rising but indicators like the RSI start turning lower—can warn that momentum is fading.

During the dot-com craze, some early adopters of technical signals recognised that leading internet stocks were diverging from their technical indicators even while headlines remained giddy. Momentum traders who relied on trend breaks noted that once a stock fell below a key moving average on heavy volume, the uptrend was probably done. Those who sold quickly saved themselves from the brutal declines that followed. In 2008, charts of major bank shares showed months of lower highs and lower lows, yet many CEOs and analysts projected reassurance. Traders armed with technical watchfulness, on the other hand, saw the writing on the wall and acted accordingly.

In a momentum strategy, the technicals guide buy and sell triggers. A typical method might be to buy a stock once it breaks to a fresh high accompanied by rising volume, then to exit if it dips below a certain support line or experiences a distinct shift in momentum indicators. The strength of full-blown momentum runs lies in how far they can carry a price before they naturally retrace. Indeed, some investors shy away from such stocks, fearing they have “already moved too much.” Yet that very scepticism can fuel continued gains because new buyers emerge on each minor pullback, convinced that as long as the trend is alive, they owe it to themselves to join in. Technical analysis can inject discipline here, helping traders avoid staying too long once signals suggest the party is ending.

Crashes, Peaks, and the Rewards of Contrarian Timing

One of the most compelling reasons to study momentum strategies is how they often reveal that buying amid gloom can trump panic selling while exiting near euphoric highs can save hard-won gains. When a severe crash hits—whether it be the financial meltdown of 2008 or the abrupt pandemic-driven plunge in 2020—most people abandon ship at the worst moments. Emotion, perhaps the biggest foe of consistent returns, screams that nothing will ever recover. Meanwhile, those who follow momentum signals might spot the first green shoots of returning strength, shifting from bearish positions to new longs. Although no method is perfect, momentum can provide a systematic way to re-enter markets instead of waiting until everyone feels confident again—and by that time, a substantial rebound may have already happened.

Similarly, when prices climb too far, mass psychology turns euphoric. Phrases like “It’s different this time” and “X stock can never go down” dominate chat rooms and financial talk shows. Momentum traders respond by monitoring technical cracks or momentum oscillators that stop confirming new price highs. Once those signals appear, it is time to reduce exposure or exit entirely. That might be a day, a week, or even a month before the official top, but capturing the bulk of a trend is frequently better than overstaying. The essence of momentum is capturing healthy runs, not waiting for the final breath of a bubble.

Meanwhile, contrarian thinking helps reinforce that momentum alone does not mean chasing simply because prices are rising. True contrarians blend the concept of momentum with caution about crowd extremes. For instance, a contrarian might wait for a strong momentum play but quickly exit if news narratives reach hysterical proportions. Similarly, when the crowd is convinced the market will never recover—akin to the early months of 2009—contrarians monitor for the first flicker of improving momentum. In this way, they merge the best of both worlds: harnessing the crowd’s energy while staying alert for signals that mania or despair has gone too far.

The Final Picture: Blending Momentum with Emotional Resilience

So, can a momentum investing strategy truly give you an edge? Evidence suggests it certainly can, particularly when balanced with an understanding of groupthink and disciplined exit strategies. However, it is not a magical formula that guarantees endless profit. If you hold a winning stock too long, hoping it will keep surging even after momentum weakens, you may pay the price. Likewise, if you ignore the emotional swirl around you, believing charts alone will protect you, you could miss major warnings. For instance, if a rumour or unexpected event triggers a swift market reversal, no system is foolproof.

Yet many of the most lauded investors incorporate momentum principles in some form, whether they call it “trend-following” or simply selling losers quickly and letting winners run. When markets are trending higher, these strategies can lock in large gains. When serious cracks appear, prompt signals minimise losses. The crucial element is not chasing momentum blindly. Rather, it involves staying aware of key behavioural cues—mass optimism or panic—and layering technical confirmations on top. This method can let you ride the current while it is strong and step away when it starts to shift.

Historic crashes do roil even the savviest. But time and again, those who reacted to early signs of falling momentum lessened the damage, preserving capital to return when prices stabilised. Similarly, those who overcame fear to deploy capital once buyer momentum returned often enjoyed eye-popping gains, while the majority remained paralysed or too sceptical to act. In essence, momentum capitalises on human tendencies—our inclination to jump on bandwagons—and flips that into a structured trading style. Though widely misunderstood, it can be remarkably effective.

Perhaps the biggest lesson is that momentum demands discipline. It rewards those who follow signals consistently, avoiding emotional swings or the urge to argue with the market. Unlike pure value strategies that can hold for years, momentum is always scanning for changes in trend. It invites quick trades if the situation changes, and it encourages letting winners run if the data still points upward. This split-second pivot is both the strength and challenge of momentum. However, for those willing to merge technical markers, psychological insights, and contrarian awareness, momentum can be far more than just another strategy floating around in financial circles. It can serve as a calculated approach to capturing the market’s strongest moves while escaping the worst carnage of each cycle.