Momentum Investing Guide: Riding Market Trends

Momentum investing is based on a simple observation: stocks that have performed well recently tend to continue performing well, and stocks that have performed poorly tend to continue underperforming. This trend persistence, documented across dozens of markets and over a century of data, is one of the most robust anomalies in finance.

The basic rule: buy the winners of the last 3-12 months, avoid (or short) the losers, and rebalance regularly.

The academic evidence

Momentum was formally documented by Jegadeesh and Titman in 1993, but practitioners had observed it for decades. Key findings:

• Universal: Momentum works in US, European, Asian, and emerging markets
• Persistent: Has been documented from the 1920s through 2025
• Significant: The momentum premium (return above the market) has averaged 4-8% annually across global markets
• Survives costs: Even after accounting for trading costs (which are higher for momentum due to frequent rebalancing), the premium remains positive

Why momentum exists

Three primary explanations:

1. Behavioural underreaction: Investors are slow to incorporate new information. When a company reports surprisingly good earnings, the stock rises but not enough. The price continues adjusting over subsequent months as more investors notice.

2. Herding and overreaction: As momentum builds, more investors pile in, creating a self-reinforcing cycle. This overshoots eventually, but the overshooting phase can last months or years.

3. Risk compensation: Some academics argue momentum returns compensate for the risk of sharp reversals (momentum crashes). The strategy works most of the time but occasionally suffers devastating losses.

How to implement momentum

Individual stock momentum

The academic version: each month, rank all stocks by their 12-month return (excluding the most recent month, to avoid short-term reversal effects). Buy the top decile, avoid the bottom decile. Rebalance monthly.

Problems for retail investors:

• Requires holding 30-50+ stocks for diversification
• Monthly rebalancing generates high trading costs
• Each sale is a taxable event (19% capital gains in Poland)
• Time-consuming research and execution

ETF-based momentum

The practical approach for European investors: use momentum factor ETFs that implement the strategy systematically.

Available momentum ETFs:

These ETFs hold approximately 350 stocks from the MSCI World universe selected for strong recent performance. The index rebalances semi-annually (May and November), reducing turnover compared to monthly rebalancing.

Cross-asset momentum

Beyond individual stocks, momentum works across asset classes. When equities are trending up, stay invested. When bonds are trending up, increase bond allocation. This is called "time-series momentum" or "trend following."

Implementation: compare each asset class's current price to its 200-day moving average. If above, hold/overweight. If below, reduce/underweight.

Simple two-asset momentum rule:

• MSCI World above its 200-day moving average: Hold 80% stocks, 20% bonds
• MSCI World below its 200-day moving average: Hold 40% stocks, 60% bonds (or cash)

Backtests show this reduces maximum drawdowns by 30-50% compared to buy-and-hold, with only modest return drag during strong bull markets.

Momentum's Achilles heel: crashes

Momentum strategies suffer periodic violent reversals. The worst:

• 2009 momentum crash: When markets bottomed in March 2009, momentum portfolios were heavily short previous losers (financial stocks) and long previous winners (defensive stocks). When the recovery began, the worst stocks surged and momentum portfolios lost 20-40% in weeks.
• 2020 COVID reversal: Similar dynamic. Momentum was short travel and hospitality stocks that crashed in March, then surged on vaccine announcements.

These crashes are rare (roughly once per decade) but severe. They typically occur at market turning points, when the trend reverses sharply.

Mitigating crash risk

1. Diversify across factors: Combine momentum with value (which tends to rally when momentum crashes). A 50/50 momentum/value portfolio is more stable than either alone.
2. Use stop-losses: Exit momentum positions that decline more than 10-15% from their peak.
3. Reduce concentration: Broader momentum portfolios (300+ stocks) crash less severely than concentrated ones (30 stocks).
4. Cross-asset diversification: Do not apply momentum only to equities. Include bonds, commodities, and currencies.

Performance in European markets

European momentum has historically shown stronger premiums than US momentum, likely because European markets are less efficiently priced (lower analyst coverage, more retail investor participation in some markets).

MSCI Europe Momentum has outperformed MSCI Europe by approximately 2-3% annually over the past 20 years, with significant variation year to year.

For Polish investors, momentum on GPW is harder to implement due to lower liquidity in mid-cap and small-cap stocks, wider bid-ask spreads, and higher proportional trading costs. Using a global momentum ETF (IWMO) is more practical than building a GPW-based momentum portfolio.

Momentum as a portfolio satellite

The most practical use of momentum for a long-term investor is as a satellite allocation:

Core-satellite approach:

• Core (80-90%): VWCE or IWDA (market-cap weighted, buy-and-hold)
• Satellite (10-20%): IWMO or XDEM (momentum factor)

This captures the momentum premium as a return booster while the core provides stable market exposure. Rebalance the core/satellite split annually.

Should you use momentum?

Yes, if:

• You understand that momentum crashes happen and can tolerate them
• You have a 10+ year horizon (long enough for the premium to compound)
• You implement via ETFs (not individual stocks) to keep costs low
• You use it as a satellite, not your entire portfolio

No, if:

• You would panic-sell during a momentum crash
• You invest in a taxable account (high turnover means high tax drag)
• You prefer simplicity (a single VWCE holding is simpler and captures 90% of the benefit)

Track your momentum allocation alongside your core portfolio in Freenance. Seeing the combined performance helps you stay committed to the strategy during inevitable underperformance periods.

Related Articles

• Growth vs Value Investing — How momentum relates to the growth-value debate
• Value Investing Guide — The contrarian counterpart to momentum
• Rebalancing Portfolio Guide — Maintaining your factor allocation