10.1 Momentum and Reversal Effects

Momentum and reversal effects shape asset prices in fascinating ways. Momentum keeps prices moving in the same direction for months, while reversals flip trends over years. These patterns stem from our cognitive biases and emotions, challenging the idea of perfectly rational markets.

Behavioral finance offers compelling explanations for these market anomalies. Underreaction to news fuels momentum, while overreaction drives reversals. Understanding these effects can inform investment strategies, risk management, and portfolio construction in the real world.

Understanding Momentum and Reversal Effects

Definition of momentum and reversal

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• Momentum effect describes asset prices continuing in same direction for 3-12 months
  • "Winners keep winning, losers keep losing" (stocks, commodities)
  • Fueled by investor herding and trend-following behavior
• Reversal effect shows prices moving opposite to recent trends over 3-5 years
  • "Winners become losers, losers become winners" (value vs growth stocks)
  • Driven by mean reversion and overreaction to news
• Key differences highlight contrasting time horizons, price movements, trading implications
  • Momentum strategies capitalize on short-term trends
  • Reversal strategies bet against long-term price movements

Behavioral factors in market patterns

• Cognitive biases fuel momentum through:
  • Confirmation bias: seeking info confirming existing beliefs (Tesla bull ignoring negative news)
  • Representativeness: assuming past performance predicts future results
  • Herding: following crowd behavior in markets (meme stocks)
• Emotional drivers of momentum include:
  • FOMO pushes investors into rising assets (cryptocurrency rallies)
  • Overconfidence leads to excessive trading and risk-taking
• Psychological factors behind reversals:
  • Mean reversion beliefs assume prices will return to average (P/E ratios)
  • Contrarian thinking bets against prevailing trends
  • Overreaction to news causes price swings beyond fundamentals
• Limits to arbitrage prevent immediate correction:
  • Transaction costs eat into potential profits
  • Short-selling constraints limit ability to bet against overvalued assets
  • Noise trader risk: irrational investors can drive prices further from fundamentals

Empirical evidence for market effects

• Momentum effect studies:
  • Jegadeesh and Titman (1993) found 12-month momentum in US stocks
  • Cross-sectional momentum compares assets to each other
  • Time series momentum focuses on asset's own past returns
• Reversal effect research:
  • De Bondt and Thaler (1985) showed 3-5 year reversals in stock returns
  • Short-term reversal patterns occur over days to weeks
• Cross-asset class evidence spans:
  • Equity markets (individual stocks, sectors, countries)
  • Bond markets (government, corporate, high-yield)
  • Commodity markets (oil, gold, agricultural products)
  • Currency markets (major and emerging market currencies)
• Robustness across time periods and regions supports global phenomenon
• Challenges to evidence:
  • Data mining concerns: patterns may be statistical flukes
  • Publication bias favors significant results over null findings

Applying Behavioral Finance to Momentum and Reversal

Behavioral explanations of market anomalies

• Limits of rational expectations theory:
  • EMH challenges: persistent anomalies contradict perfect efficiency
  • Adaptive Markets Hypothesis: efficiency evolves with changing market conditions
• Behavioral explanations for momentum:
  • Underreaction to new information leads to gradual price adjustments
  • Gradual information diffusion across investor groups
  • Disposition effect: holding losers, selling winners too soon
• Behavioral explanations for reversals:
  • Overreaction to extreme news causes price overshooting
  • Investor sentiment cycles between optimism and pessimism
  • Reversion to fundamental value over long horizons
• Momentum-reversal interaction:
  • Transition from momentum to reversal as trends mature
  • Time-varying nature affected by market conditions (volatility, liquidity)
• Market efficiency implications:
  • Slow incorporation of information into prices
  • Persistent profit opportunities challenge strong-form efficiency
  • Adaptive efficiency: markets become more efficient over time
• Practical applications include:
  • Momentum strategies: trend-following, relative strength
  • Contrarian strategies: value investing, mean reversion
  • Risk management: diversification, stop-loss orders
  • Portfolio construction: factor investing, smart beta approaches