Momentum Investing Explained

Momentum investing means systematically buying stocks with strong recent performance and selling those with weak recent performance, on the empirical basis that price trends tend to persist. It has the strongest historical evidence of any investment factor, has been documented in markets for over 200 years, and remains one of the few strategies that has worked consistently across geographies and asset classes. It also feels the most uncomfortable to execute.

What it measures

Momentum investing focuses on recent price performance:

• 3-month price return: Short-term momentum signal.
• 6-month price return: Medium-term momentum.
• 12-month price return: Long-term momentum, the most-studied window.
• Relative strength: Performance versus benchmark or sector peers.
• Volume trend: Rising volume on advancing stocks confirms momentum.
• Distance from highs: Stocks near 52-week highs often continue advancing.

The classic academic momentum factor uses a 12-1 month return: total return over the past 12 months excluding the most recent month (which often shows mean reversion). Stocks ranked in the top decile by 12-1 momentum have historically outperformed those in the bottom decile by approximately 8-10 percentage points annually.

This effect has been documented in:

• US stocks (1927-present)
• International developed markets
• Emerging markets
• Bonds
• Currencies
• Commodities
• Even individual real estate markets

The persistence across asset classes and time periods makes momentum one of the most robust empirical findings in finance.

How to use it in practice

Why does momentum work? Several theories:

Behavioral: Investors underreact to news, slowly incorporating information into prices. This creates trends as the full impact of catalysts is gradually absorbed.

Information cascades: Early adopters identify good investments, attracting others who confirm the trend, attracting still more buyers in self-reinforcing cycles.

Risk premium: Momentum stocks may be inherently riskier (higher volatility, drawdown risk), justifying higher expected returns.

Limited arbitrage: Despite being well-known, momentum is hard to exploit due to high turnover, transaction costs, and behavioral discomfort. This limits arbitrage and preserves the premium.

The 2024-2025 market provided classic momentum examples:

$NVDA: After the 2023 inflection, AI-driven earnings produced massive momentum. Each quarter's outperformance reinforced demand for the stock. Investors who bought the strength repeatedly were rewarded.

$META: After the 2022 bottom, the stock generated sustained momentum through 2023-2024 as efficiency gains and engagement metrics improved.

$AVGO: AI-related demand drove sustained momentum through 2024-2025, with the stock consistently outperforming.

$LLY: GLP-1 weight loss drug success generated multi-quarter momentum through 2023-2024.

$WMT: Operational excellence and digital transformation drove sustained momentum through 2024-2025.

Common momentum frameworks:

Pure price momentum: Buy stocks with the strongest 12-month returns. Hold for 3-12 months. Rebalance regularly.

Relative strength: Buy stocks outperforming their sector or the broader market. Sector relative strength reduces sector concentration risk.

Earnings momentum: Buy stocks with consistent positive earnings surprises and rising estimates. Combines fundamental and price momentum.

Multi-factor momentum: Combine price momentum with quality, value, or other factors to reduce drawdown risk.

The mechanics of momentum investing:

• Look-back periods: Standard is 12 months minus 1, but 6 months and 9 months also work.
• Holding periods: 3-12 months typically. Longer holds reduce turnover but may capture less premium.
• Rebalancing frequency: Monthly to quarterly typical. More frequent rebalancing increases costs.
• Position sizing: Equal weight or volatility-weighted typically. Concentrated position sizing increases idiosyncratic risk.

The challenges with momentum:

Periodic crashes: Momentum strategies experience periodic severe drawdowns when leadership rotates rapidly. The "momentum crashes" of 2009, 2020 March, and 2022-2023 produced large losses.

High turnover: Constantly buying winners and selling losers generates significant trading costs and tax inefficiency.

Behavioral discomfort: Buying stocks at all-time highs after they've already gained substantially feels deeply wrong to most investors. Selling stocks immediately after they decline feels equally wrong.

Crowding: As momentum has become widely adopted, crowding can amplify drawdowns when the trade unwinds.

For implementation:

• Tax-advantaged accounts: Momentum's high turnover makes it more tax-efficient in IRAs and 401(k)s.
• Smart beta ETFs: Momentum factor ETFs (like MTUM) implement the strategy systematically with lower costs than active management.
• Multi-factor combinations: Combining momentum with quality and value reduces drawdown risk.
• Trend filters: Some investors avoid momentum during bear markets when the strategy's drawdowns are largest.

Common mistakes

Confusing momentum with growth. Momentum is a price-based strategy; growth is a fundamentals-based strategy. They often overlap but are distinct.

Selling winners too early. Many investors take profits after modest gains, missing the full momentum continuation. The strategy requires letting winners run.

Holding losers too long. Momentum requires selling weakness. Investors who refuse to sell declining stocks abandon the strategy.

Trying to predict momentum reversal. Momentum eventually reverses for any individual stock, but predicting when is extremely difficult. Systematic implementation produces better results than discretionary attempts.

ACCE perspective

Momentum is a 25% component of our overall scoring system, alongside growth, value, and quality. We weight 3-month return at 30%, 6-month return at 25%, 12-month return at 20%, relative strength versus benchmark at 15%, and volume trend at 10% within the momentum score.

Including momentum in our scoring captures one of the most robust empirical factors in investing. The combination of momentum with growth, value, and quality produces better risk-adjusted returns than any single factor alone.

For investors building portfolios, momentum is most reliably implemented through systematic strategies (factor ETFs or rule-based screens) rather than discretionary trading. The behavioral discomfort of buying recent winners makes discretionary momentum particularly difficult to execute consistently. Multi-factor approaches that combine momentum with other factors reduce drawdown risk while preserving most of the momentum premium.