Momentum investing, a strategy that seeks to capitalize on the continuance of existing market trends, has gained significant popularity in global markets, and investors are increasingly curious about its effectiveness in India. At its core, momentum investing involves buying assets that have shown upward price movement in the past and selling those that have exhibited downward trends. But the question remains: does momentum investing work in India's unique financial ecosystem?

This blog aims to explore the concept of momentum investing, its potential viability in the Indian context, and key factors to consider before adopting this strategy.

Understanding Momentum Investing

Momentum investing is based on the idea that stocks that have performed well in the recent past will continue to do so in the near future. The theory relies on the observation that market movements are often influenced by investor psychology, where trends, once established, tend to persist.

The strategy dates back to the 1990s and was solidified by academic research. Academics like Narasimhan Jegadeesh and Sheridan Titman demonstrated that stocks with high returns over a 3-to-12-month period tend to outperform, at least in the short term.

Momentum investors typically use two approaches:

  1. Relative Strength Investing: Buying stocks that have performed better than their peers.
  2. Absolute Momentum Investing: Purchasing stocks showing positive momentum in their own prices, regardless of how other stocks perform.

Momentum Investing in India's Stock Market

India's stock market is significantly different from markets like the U.S. or Europe in terms of size, liquidity, market sentiment, and the proportion of retail investors. This makes the applicability of momentum investing in India somewhat unique.

  1. Historical Performance of Momentum Investing in India

    Historical data suggests that momentum investing can work in the Indian market. Multiple studies and research reports have pointed out that Indian stocks that perform well in the short term often continue to rise for a certain period. For instance, a 2017 study by Raghavendra Rau and M. V. Shiju found that momentum portfolios in India delivered substantial returns over a 3-to-12-month holding period.

    Moreover, some mutual funds and quantitative investment firms in India have already employed momentum-based strategies, and many have seen positive results, albeit with higher volatility compared to other investment strategies like value or growth investing.
  2. Sectoral Momentum in India

    Sectoral momentum is particularly prominent in India. Indian markets tend to see sectoral rotations, where one or a few sectors outperform the rest for extended periods. Momentum investors often identify these outperforming sectors and align their portfolios accordingly.

    For instance, sectors like Information Technology (IT) and Financial Services have had periods of robust performance driven by sector-specific catalysts, and momentum investors benefited from riding these waves.

Key Challenges of Momentum Investing in India

While momentum investing can potentially generate significant returns, it is not without challenges, especially in a market like India.

  1. Market Volatility

    Indian markets are known for their relatively higher volatility compared to developed markets. Events like elections, changes in government policy, or external shocks (such as global economic downturns) can cause significant short-term fluctuations. Momentum strategies can be highly sensitive to this volatility, leading to sharp drawdowns during periods of market corrections.
  2. Transaction Costs

    Momentum investing often involves frequent buying and selling of stocks, which can lead to high transaction costs, including brokerage fees and taxes such as the Securities Transaction Tax (STT) and capital gains tax. These costs can eat into profits, especially for retail investors who may not have access to low-cost brokerage options.
  3. Short-term Nature

    The effectiveness of momentum investing lies in short- to medium-term stock performance, typically over 3 to 12 months. This short-term focus can pose risks for investors with a long-term outlook. Momentum stocks are prone to quick reversals, meaning that timing plays a crucial role in the success of the strategy. Investors who are not adept at timing the market may find it difficult to consistently generate profits.
  4. Behavioral Biases

    Momentum investing hinges on the idea that trends persist because of investor psychology. However, behavioral biases such as overconfidence, herd mentality, and emotional decision-making can lead to mispricing in the market. While this creates opportunities for momentum investors, it also increases the risk of getting caught in speculative bubbles or market corrections.
  5. Limited Data and Information

    One major limitation in the Indian context is the availability of high-quality, timely data. Although stock exchanges like the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) have made significant strides in providing comprehensive data, it is still less accessible compared to more developed markets. Momentum strategies often rely on sophisticated quantitative models that require extensive data, which can be a challenge for individual investors in India.

Should You Adopt Momentum Investing in India?

Momentum investing can work in India, but it is not a one-size-fits-all strategy. Investors considering this approach need to be mindful of several factors:

  1. Risk Tolerance: Momentum investing can offer high returns but comes with higher risks. Investors must have a high tolerance for volatility and the ability to endure market swings.
  2. Discipline and Timing: The success of momentum investing relies on strict discipline and impeccable timing. It may not be suitable for investors who prefer a passive, buy-and-hold approach.
  3. Diversification: Given the inherent risks, it is advisable to diversify a portfolio that includes momentum stocks. Balancing momentum-based investments with value or growth strategies can help mitigate some risks.
  4. Professional Management: Retail investors may find it difficult to implement momentum strategies on their own due to the complexity involved. Opting for professionally managed momentum mutual funds or quant funds can be a good alternative.

Conclusion

Momentum investing can work in India, but like any investment strategy, it comes with its own set of challenges and risks. While the Indian market has shown signs that momentum strategies can yield positive results, success depends largely on timing, discipline, and the ability to manage volatility. Investors should carefully evaluate their risk appetite and consider professional management before diving into momentum-based investments.