When not to ride momentum

Warren Buffett said, "Be fearful when others are greedy and greedy when others are fearful." But we often act otherwise and end up making hefty losses. And one of the most common reasons behind this is 'momentum investing'.

Here is how the cycle of momentum investing goes:

Phase 1: Institutional investors start investing in a stock. Stock gradually starts moving upwards.

Phase 2: A few more institutional and smart retail investors make investments in the stock. The stock starts moving up even more rapidly. It still appears to be a rational investment.

Phase 3: In this irrational phase, the stock has already rallied a lot and its price has started moving way ahead of its fundamentals. However, ignoring these fundamentals, retail investors start investing in the stock. They regret their decision later. These investors are more influenced by their friends or relatives who are already making money in the stock. However, during this phase, big investors, who had invested in the first two phases, start exiting the stock gradually.

Phase 4: Institutional investors exit the stock, leaving retail investors in a trap. The stock price starts nosediving, while investors who are stuck keep waiting for a recovery, which seldom arrives.

Being rational in the stock market is a tough task, especially when the stock price is flying high. But at the end, only rational decision-making can save investors from these momentum plays. Before buying momentum plays, investors should do in-depth research. Many times, stocks rally on some short-term positive news just to come down later.

Take the case of the recent boom and bust in graphite-electrode companies, Graphite India and HEG. These stocks went up because of a pollution ban in China, when the prices of graphite electrode suddenly shot up from $3000/tonne to $15,000/tonne within just two years.

Being leading producers of graphite electrodes, HEG and Graphite India's stock prices multiplied by 19 and 10 times, respectively, in less than two years. However, over the last one year, their stock prices have corrected by more than 50 per cent on the back of a fall in the prices of electrodes, higher imports, higher raw-material costs and reopening of the closed plants in China.

Investors who were aware of the sudden boom and bust of commodity cycles and therefore exercised rationality could have easily avoided the fall.