Momentum stocks that are going up may look like winning investments, but they can simply be gambles in disguise

Successful investors try to arrange their portfolios so that they more-or-less automatically tap into the profit and long-term growth that inevitably comes to well-established companies operating in relatively free economies in prosperous times.

It’s essential to diversify, as you do if you follow our three-pronged investment approach. But in addition, successful investors need to limit their exposure to what we call “bad ideas” like investing heavily in stocks that are going up.

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Why not just buy stocks that are going up?

Investors sometimes ask why we bother delving into such excruciating details of the finances and fundamentals of stocks we recommend. Why not just buy the stocks that are going up, then place stop-loss orders so we sell them when they quit rising?

This is a partial description of the momentum approach to stock market investing. You buy stocks that are rising and reporting rising earnings, or earnings gains that beat expectations. You sell when the stocks quit rising and/or when earnings growth falters.

This approach would work great if nobody else ever thought of it.

The problem is that there’s a lot of competition when you only buy the stocks rising with surprisingly fast earnings gains—and even more competition when you sell. As a result, you miss out on much of the early part of the rise. If you get in too late, then get out at the first hint of bad news, you may wind up selling at a loss. Doing that a few times can put a deep dent in the value of your portfolio.

If you look at a list of top-performing mutual funds, you’ll often find so-called “momentum investors” at the top of the list for a year. But it’s a hard act to maintain. A year later, you’ll often see a different set of momentum investors at the top of the year’s list of top performers.

In contrast, if you look at a list of top performers over a period of a decade or two, you’ll usually find that the people in the top spots invest much as we do. They look at all the excruciating details, and temper it with a consistent blend of diversification and common sense.

Key point: Trying to buy stocks that are going up is a much riskier venture than it may seem. Momentum investing implies that you can predict what will happen to a stock’s share price. But many factors that you can’t possibly anticipate will determine how the price performs. In effect, momentum investors are gambling on the trend in the price of the stock, and that’s a gamble many investors lose.

Buy little-known stocks that are going up—rather than momentum favourites

It’s not always advisable to buy the top rising stocks. On the other hand, little-noticed stocks sometimes rise for months before the reason for their strength becomes apparent

Note that if you always try to buy below the market, you’ll always get a “fill” on stocks with hidden flaws. They’ll always come down into your buying range … and they’ll keep on falling.

But you’ll never get to buy the other kind of stock—the kind that keeps going up. These stocks will always seem too expensive, and they’ll go on to get even more expensive. But you need a few of these ever-more expensive stocks to offset the losses from those that get cheaper and cheaper.

There’s no easy answer to the buy-now-or-wait dilemma for current top rising stocks. At times it may pay to hold off—for instance, a company’s stock will often rise when it announces a stock split, then fall after the split takes effect.

In the end, though, if a rising stock is truly worth investing in, you should be willing to buy it at current prices, even if that means you run the risk of having to sit through a 5% to 10% setback. Before it slips into its next 5% to 10% setback, after all, it may first go up 50% to 100%.

Bonus tip: The risk of stocks that are going up can be balanced with value stocks in your portfolio

Most successful investors hold some growth stocks and some value stocks at any given time, depending on where they see the best opportunities. Value stocks are stocks trading lower than their fundamentals suggest. They are perceived as undervalued, and they have the potential to rise.

Growth stocks, on the other hand, are firms whose earnings growth has been—or is projected to be—above the market average, and likely to remain above average. Some pay small dividends, but most don’t. Instead, they re-invest their cash flow in the business, to promote their growth.

Together, growth stocks and value stocks can make a winning combination. A growth stock can be a top performer when the company is growing. However, a single quarter of bad earnings can send it into a deep, but 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.

It is hard to predict when the momentum of a stock will stop. How do you make this determination for your investing career?

Have you ever bought a rising stock that ended up as a money loser? What did you learn from the experience?