Examination of long-run performance of momentum portfolios: Implications for the sources and profitability of momentum
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This dissertation investigates the long-term performance of momentum portfolios. Its results show striking asymmetries for winners and losers and imply potentially different causes for the winner and loser components of momentum. After separately examining winners and losers relative to their respective benchmark portfolios with no momentum, we find winner momentum is smaller in magnitude, persists only for six months, and its higher return fully reverses. This is consistent with the notion that winner momentum is an overreaction to positive news and potentially destabilizing. Loser momentum is larger in magnitude, lasts for about one year, and its lower return does not reverse in the long run. This is consistent with the notion that loser momentum is an underreaction to negative news and suggests investors hold on to losers for too long. The lack of reversal for losers departs from prior studies whose findings are driven by the use of monthly rebalanced portfolio. Rebalancing cumulates an upward bias caused by noise-induced price volatility, which disproportionately affects losers more. This greater upward bias in losers creates an illusion that the winner minus loser return reverses. More appropriate approaches such as the buy-and-hold portfolio documents significantly less reversal. Existing theories that potentially conform to the overreaction of winners and underreaction of losers include overconfidence (Daniel, Hirshleifer, and Subrahmanyam, 1998), representativeness and conservatism (Barberis, Shleifer, and Vishny, 1998), interaction between agents holding asymmetric information (Hong and Stein, 1999), and investors' asymmetric response to fund performance (Vayanos and Woolley, 2013).
General Audience Abstract
The method employed to study a phenomenon can have an immense impact on our understanding. In the specific context of momentum - a strategy of buying stocks with good past performance and selling stocks with bad past performance, we show that the methodology choices as simple as how you form a portfolio and what you benchmark the portfolio against can produce significantly different results than previously documented. The documented pattern that momentum reverses over the long run, is confounded by the use of rebalanced portfolio and benchmarking winner and loser stocks against each other. Rebalancing embeds an upward bias into the return, with the bias increasing in the amount of noise in the price. Losers, having lower prices and smaller market values, suffer more from the upward bias. Thus, the reversal of the winner over loser return is more due to the inflated loser return from the bias than an underlying economic phenomenon. We confirm this by using a host of other portfolio formation methods that are known to mitigate the bias. With each of the other method, the loser return and the reversal are significantly reduced. We also suggest comparing winners and losers to a neutral benchmark with no momentum, rather than with each other to study the long-term pattern of momentum. This exercise turns out to be fruitful in that we find asymmetric behavior for winners and losers. Winner momentum fully reverses while loser momentum persists. The significance of the new results is that they affect our understanding of what drives momentum in the first place. The reversal of winners implies that winner momentum is an overreaction to positive news and potentially destabilizing. The persistence of losers indicates that loser momentum is an underreaction to negative news and implies investors hold on to losers for too long.
- Doctoral Dissertations