Go with the flow…

The momentum story has power because it can be a self-fulfilling prophecy If investors buy into the momentum story and buy stocks that have gone up in the past, these stocks will go up further. The momentum can continue as long as you can new investors are attracted to the stock, pushing up demand and prices. Thus, the strongest argument for momentum is herd behavior. In general, there are three reasons given for why investors may indulge in this herd behavior and why you should be able to take advantage of it.

q      Investors learn slowly: If investors are slow to assess the effects of new information on stock prices, you can see sustained up or down movements in stock prices after news comes out about the stock – up movements after good news and down movements after bad news. The investors who are quickest at assessing the effect of information will profit as investors who are slower at assessing impact gradually come on board.

q      Investors learn by watching other investors: Some investors learn by watching other investors trade rather than by analyzing fundamentals. If you accept this view of the world, sustained price increases accompanied by high trading volume will attract new investors to a stock.

q      Investors weight the recent past much more than they should: Psychologists have uncovered fairly strong evidence that human beings tend to weight recent information far more than they should and old information far less than they should. In other words, a positive news announcement by a company can lead to a disproportionately large increase in its stock price as investors react to the announcement.

Momentum stories almost invariably are accompanied with a sense of urgency. You need to get on the momentum bus or it will leave, you are told.