There are three main widely-recognized styles of investing. These are value investing, growth investing and momentum investing.
Value investing can be defined as buying stocks trading at a low valuation compared to an estimate of intrinsic value, while growth investing can be defined as buying highly valued stocks on the expectation that their valuations will continue improving as the company reports encouraging results. Meanwhile, momentum investors try and chase in on trends.
There's some debate over whether momentum investing is really investing or if it is speculating, and if value and growth can really be as easily distinguished as simple ratios like the price-earnings ratio might suggest. However, for the purposes of this article, I'm going to stick with the definitions outlined above.
Styles of investing
All three of the above styles can achieve results. There's always going to be more than one way to get rich. Issues arise, however, when investors cross the boundaries and don't know which style they're following.
The most relevant example of this right now is momentum trading. Over the past 12 months, some stocks have achieved outstanding results. Many of these started as growth investments, and as investors have piled in, rising stock prices have attracted more cash, driving a virtuous cycle. The valuations of these companies have become so inflated, the relationship between price and value has completely broken down. Nevertheless, they have continued to rise in value, and momentum investors who correctly estimated the trend (and helped drive it) have benefited.
There always needs to be a clear line between momentum trading and any other type of investing. Unfortunately, many of the investors who were caught up in the recent market euphoria have been unwilling or unable to make this disconnect. This is where problems start to emerge.
Momentum vs. growth
If one buys a stock as a momentum investment or trade, one should have clear risk limits, be aware of the downside and be willing to take a loss if the stock starts moving in the wrong direction. Like any other type of trading, momentum trading requires tight risk controls and an appreciation of the market's brutality.
On the other hand, when one buys a growth or value investment as a long-term holding, one is not looking soley at the upside potential and risks that could result from arbitrary market movements. Instead, value and growth investors focus on the company's strengths, weaknesses, opportunities and threats in the long-term, as well as the valuation they think the stocks deserve.
Put simply, momentum investing/trading and growth or value investing are two different disciplines that require different skill sets. Unfortunately, if one buys a momentum play without understanding what it is, the trade can quickly fall apart, and losses will grow.
This is what is happing in some areas of the market right now. Investors have been sucked into seemingly high growth and speculative businesses, which have seen their valuations rise to disproportionate levels, believing these are growth investments.
But in many cases, these were just momentum plays. As a result, some investors have been left nursing large and losses as the stocks have fallen, the momentum has faded and they haven't realized the change in style.
True momentum investors would have bought, rode the stock higher, and sold at the first sign of trouble.
Some individuals may struggle with this approach because it could involve the process of selling at a loss. However, here loss avoidance kicks in, and investors may start to say, "it's a long-term investment."
That may be true, but the question is, will the company ever be able to achieve the growth required to propel it back to all-time highs? Unfortunately, in some cases, that seems unlikely.
In this situation, the best outcome for investors may be to admit a mistake, sell, take the loss and move on to the next company.
Sure, this might not be the perfect outcome, but there's rarely an ideal outcome in investing. Sometimes we just have to muddle through.
Disclosure: The author owns no share mentioned.
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