Industry insights

Breaking down the movement: what is momentum investing?

  • February 15, 2021
  • Noah Weidner

What do Tesla, Etsy, and Moderna all have in common? Well, they were some of the biggest stocks of 2020. A ‘hype vehicle’ propelled these companies to market stardom, taking them to 2x, 4x, even 6x in mere months. But, what came first–the hype or the company? Maybe they’re one and the same.

Trends in markets don’t happen in a bubble. There are red hot sectors like clean energy, new IPOs, electric-vehicles, SPACs, space travel, genomics, and they cycle in and out of relevance. Sometimes, a company captures a cross-section of multiple trends. These companies quickly boil up, gain traction – either from big money or retail investors – and turn into momentum stocks.

There’s a name for seeking out trendy companies and riding the metaphorical “stock price wave” that comes with it. It’s called momentum investing and it has become one of the most popular ways that investors are maximizing their returns. The first step is identifying a stock (or stocks) that are trendy, socially popular, and are rising over a period of time. Maybe you see it at its one-year high or in passing on r/WallStreetBets. Maybe it’s a giant meme on Twitter. Whatever the reason, momentum investors want to be ahead of the hoards of retail investors rushing into them.

For some investors, hopping on “the bandwagon” ends up being highly lucrative–but, those who don’t get out at the right time can be punished by volatility and swift moves. So, should you do it?

Breaking down the movement

Momentum investing is basically an evolution of ‘word-of-mouth.’ If your friend talks about a product or vacation they had, there’s some psychology saying that people will decide they want to buy the same product or have the same vacation. Except in this case, it’s not just about a product or vacation–it’s about missing out on big gains from investing in a stock or cryptocurrency. Fear of Missing Out (FOMO) is a big driver behind retail investors’ obsession with momentum and you kind of can’t blame them.

If you bought Tesla at the start of 2020, you’d have made 696% by the start of 2021. If you had bought Bitcoin at its all-time high during the December 2017 crypto bull run, your money would have more than doubled by January 2021. If you bought GameStop back in September 2020, you’d be up more than 700% – and, that’s assuming you didn’t sell when it was much higher because of the GameStop short squeeze. Traditional money managers and robo-advisors might advise investing in index strategies such as the SPDR S&P 500 ETF, but to some investors $SPY looks like a snail fund. It takes years to double. Why wait five years when you can double your money in five months?

Through that lens, it’s easy to understand why momentum investing has taken off. It’s seen as an easy way to mint money, pursuing quick-moving and volatile stocks. It’s also a fitting strategy for the times. With so much interest in investing, retail investors – empowered by no-commission brokerage apps and a wealth of online tools–can invest in hoards and affect markets.

Should investors get in on the action?

The COVID-19 pandemic and the GameStop short squeeze offer some evidence that momentum is just getting its feet wet. These two events prompted millions of new investors to sign up on brokerage apps and their presence is being felt. 

In the weeks after the GameStop short, other highly-shorted companies such as AMC Entertainment and Virgin Galactic took off as well. Elon Musk started tweeting about Dogecoin, prompting the cryptocurrency to take off. When investors on r/WallStreetBets even murmur about investing in a stock or fund, it seems to take off. Ultimately, this is emblematic of a change in markets and how they react. This simply was not possible 20 or 30 years ago.

The promise of quick cash, timing the market, and huge returns are not the story for all investors. Timing is the name of the game with momentum. If you’re not in before the stock gets beefed up by new investors, you might be too late. If you get in too late, that could lead to significant losses. Just ask the guys who bought GameStop while it was still $300.

The reality is that there are lots of investors who just buy what their friends are buying; some people buy what they read about on Reddit or Twitter. They might even be successful sometimes! However, buying trendy stocks isn’t necessarily day trading or investing. In fact, it’s probably speculation and that means that their success is lucky at best. They might be swift to share their successes (think: 200% gains), but they might not be so transparent about their losses (think: down 58%). 

Momentum investing involves understanding human psychology, the stock market, and how online communities work. There’s no guarantee and there are more responsible investment decisions you can make. Either way, before you buy a stock, do your research on it. For example, you can use the Front app to get a quick look at its company financials, stock performance, and news coverage–all captured in a single score called FISCO.

Investing can set you up for a financially secure future, or rip through your savings, if you’re not careful. Use the game, but don’t get played. Best of luck, investors. If you’re up for the challenge, you might just find the next trending stock with a stock-screening app like Front.