Momentum Investing: Why the Sky Keeps Falling

July 10, 2015

In physics, the concept of momentum refers to the quantity of motion an object has. A heavy ball rolling down a steep hill has a lot of momentum and therefore requires a significant amount of force to stop. Over the years, the concept of momentum in investing has also gained… momentum. For some, financial momentum represents an opportunity to make money, while for others, it causes an unfortunate loss of money.

 

There is a growing body of empirical evidence that suggests that due to the emotional and often irrational behavior of investors, rising asset prices will continue to rise and falling prices will continue to fall. Consider the following recent scenario: a couple of days ago, the Chinese stock market began selling off. As it fell more people panicked and also sold. Because those individuals sold, the price fell even further, causing even more individuals to panic and sell, causing the price to fall even further! What ends up happening is a slight sell-off gathers steam as more and more individuals get nervous, furthering the sell-off. Conversely, prior to the sell off the Chinese market pushed higher and higher. As it gained momentum upward, more and more individuals got excited at the prospect of gains and bought into the market thereby pushing the prices up even further. Consequently, the market continued to rise. Often, the result of momentum in either direction causes an asset to rise higher than is justified by the underlying fundamentals, and when it corrects, it falls harder than it probably should for the same reason. Some individuals recognize this and try to make money by buying into the upward momentum, or shorting on the downward momentum. The trouble is that it is incredibly difficult to time the market and unless you know when the top is going to peak and sell at precisely the right moment, you’re more likely than not to get burned.

 

The best thing you can do as an investor when it comes to the dangers of momentum investing is to be aware that it exists. The markets are predicated on rational, efficient behavior, but they are also run by human beings and human beings have a long history of acting irrationally. As momentum gathers on markets, whether in China or elsewhere, it becomes increasingly crucial for you as an investor to be well aware of your tolerance for risk and your ability to handle the ups and downs when they get out of hand. If you’d like to learn more about other aspects of financial behavior or speak with an advisor about the appropriate allocation for your ability to handle risk feel free to check out our articles page or contact an advisor.

 

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