Forget trawling through annual reports and accounts and worrying about balance sheets, profits and price-earnings ratios. It all takes a back seat if you're playing the momentum game. Instead, all you need to do to make money is buy shares that are already going up, because there's a very good chance that they will keep going up, for longer and higher than you might expect.
I don't know who coined the phrase, 'the trend is your friend', but there's a lot of truth in it. This may sound a bit too simple, but it does make sense as a strategy. The scientists among you will recall Newton's physical law of momentum. It says that any object in motion tends to stay in motion, in the same direction, until some outside force causes things to change. In much the same way, a stock in a trend, or with momentum, tends to keep going in that direction until an outside force exerts influence on it. In the sphere of share prices, that outside force can be any of a number of things; changes in fundamentals perhaps, a big news story, or a switch in investor psychology. And, as so often happens, the stock moves ahead of overt public awareness of such forces.
In other words, momentum investing is all about buying shares in companies that are moving forward at a faster rate than the market or than the market currently expects, or in other words, showing positive relative strength. In a perfectly efficient market – as stock markets are supposed to be - this system potentially couldn't work since everything there is to know about a company, or share price, would be known, by everyone, everywhere, simultaneously. But as we all know, markets are not perfectly efficient, so even if a share is already highly rated, investors may not yet have priced in all positive news about the stock, or factored in emerging good news. Momentum investors also look for average or poorly performing companies that are turning themselves around. And as investors begin to anticipate improved performance, so the shares rise providing the momentum investor with an opportunity to cash in.
