Momentum investing strategies may sound like a simple way to beat the stock market, but in truth, it’s just your broker who profits in the end.

Many investors are particularly attracted to momentum investing strategies. These momentum investing strategies focus on growth stocks—but with a shorter-term focus. Momentum investors like to trade actively and always hold fast-rising stocks that are reporting higher profits. These momentum investors don’t mind paying a high price, because they plan to sell quickly if the rise begins to falter.

At TSI Network, we think investors should avoid momentum investing strategies—and here are some of the more common momentum investing strategies to stay away from:

The Positive Earnings Surprise

This momentum investing strategy is called the “positive earnings surprise.” It occurs when a company exceeds brokers’ earnings estimates. At the same time, momentum investors view a “negative earnings surprise”—lower-than-expected earnings—as a sell signal. They use a variety of formulas to make buy and sell decisions, but essentially all come down to “buy on strength and sell on weakness.” So they tend to pile into the same stocks all at once, and the gains that follow are something of a self-fulfilling prophecy.

One key problem is that when the stock’s rise falters, momentum investors try to get out as a group, but there are never enough buyers. This leads to violent price fluctuations for these stocks, or the mutual funds and ETFs that hold them. When you hear that a stock reported a 10% earnings gain and its shares dropped 25% to 50%, it often means that the momentum investors who owned it were hoping for, say, a 12% earnings gain.

Leapfrogging

Leapfrogging is a form of momentum investing where investors jump from one stock to another, routinely switching out of the laggards in their portfolio and into funds with better performance. But basing investment decisions on performance alone is bound to cost you money sooner or later.

Leapfrogging is a bad investment strategy because it raises your risk of investing in, say a mutual fund or ETF that owes its performance to having gambled and won. When gamblers luck turns sour, they may give back all of their winnings and more besides.

Fortune reversal—momentum misinterpreted

Some investors recognize the error of using momentum investing strategies. However, they actually fall victim to a type of “negative” momentum strategy.  For example, when a fund they own goes up “too far and too fast,” as the saying goes, they sell and switch the money into a lagging fund, on the theory that funds alternate between leading and lagging. But that puts you at risk of selling your best funds way too early. It also puts you at risk of buying funds that own a lot of bad stocks. These funds may go much, much lower.

Regardless of whether you routinely sell laggards to buy leaders, or sell leaders to buy laggards, you are making the same mistake: you are still basing your investment decisions purely on investment pricing, and ignoring investment quality. This is why momentum investing strategies never produce strong long term investment results. There’s a big random element in investment pricing. In contrast, investment quality is the key to long-term safety and profit.

Here a couple of tips to help your profit from growth stocks

1. Beware of investment systems all together

   Momentum investing strategies can come in many forms. For example, momentum investing systems can include strategies to avoiding risk by buying put options to give you a way to avoid losses on your holdings, or using stop-loss orders to sell falling stocks before they drop too far. Plans like these are sure-fire ways to generate commission income for your broker. They can cut your risk in certain circumstances, but they are even more effective in cutting profit. They generally leave you with meagre returns at best.

   Again, the best investment plans or systems revolve around choosing high-quality investments and diversifying your holdings.

2. Balance your growth portfolio with value stocks

   Most successful investors hold some growth stock picks and some value stocks at any given time, depending on where they discover the best opportunities. Adding value stocks to your growth stock holdings can lower your portfolio’s volatility

   Value stocks are stocks trading lower than their fundamentals suggest. They are perceived by investors as undervalued, and have the potential to realize their full value. Many technology stocks, for instance, start out as growth stocks and transition into value stocks.

Together, growth stocks and value stocks can form a winning combination. A growth stock can be a top performer while the company is growing. However, a single quarter of bad earnings can send it into a deep, though often temporary, slide. Value stocks can test your patience by moving sluggishly for months, if not years. But they can make up for it by rising sharply when investors discover their true value.

Did you succumb to the allure of momentum investing strategies when you were investing? Was it profitable for you? Share your insights with us in the comments.