Behind the ‘momentum’: Overconfident investors believe that their ability to evaluate a stock is better than it truly is, the authors say.
Photo: adrian dennis/Agence France-Presse/Getty ImagesMomentum investing—buying stocks that have recently performed well, in the hopes that they will continue to outperform—has proved its potential as a profitable strategy. But what makes it work? Why do stocks continue to rise without fresh information to fuel their ascent?
Our research suggests an explanation: Investors tend to have too much confidence in their own ability to evaluate stocks, and too little in the abilities of others.
Momentum is often defined as the tendency of stocks that outperformed the market in the previous three to 12 months to continue to outperform in the next three to 12 months. To be precise, if you rank, say, five or 10 stock portfolios by their performance over any period within the past three to 12 months, they typically will maintain that ranking over the same period ahead.
Of course, that isn’t always the case. For example, in the U.S., the momentum effect has been stronger for small-capitalization stocks and growth stocks. It also tends to be stronger in North America and Europe than in Asia.
Momentum also is more consistent during bull markets and periods of positive investor sentiment. It has failed spectacularly on occasion; typically during recoveries from crises—for example, the Great Depression and the 2007-09 global financial crisis. In both cases, coming out of a crisis, recent losing stocks outperformed recent winners, reversing their ranking.
But momentum is more the rule than the exception. One possible explanation is that markets tend to underreact to information. For example, favorable information may be revealed that should cause a $10 stock to increase in price to $15, but the price actually increases only to $14, and then later drifts up to $15. An alternative interpretation is that markets tend to overreact, but with a delay. For example, the price may initially fully react to the information and increase to $15, but later investors may choose to continue to buy the stock, pushing the price to $17.
There’s evidence for both interpretations. But what’s behind all that underreaction and overreaction? We argue that the basic reason for both is overconfidence among investors. Overconfident investors believe that their ability to evaluate a stock is better than it truly is, and they underestimate the ability of competing investors to know something that they themselves don’t already know.
To understand how these biases influence share prices, suppose some information that increases the value of a company’s shares becomes generally available. Some overconfident investors will buy aggressively on that information, putting upward pressure on the share price. But others, equally confident, will be skeptical of the justification for the upswing, and so will sell into it—tempering the stock’s price gains and stretching them out over time. In other words, lending the stock upward momentum, instead of a quick ascent to a price justified by the stock’s fundamental value.
That explains apparent underreaction, but what about overreaction? This can happen when some investors receive favorable information about a stock later than others. Because of their skepticism, they ignore the possibility that other investors had observed the information earlier and that it is already fully, or almost fully, reflected in the share price. When this is the case, these latecomers will drive the price still higher.
Overreaction ultimately can lead to a reversal, but this scenario has become less common, and the reversals in recent decades have generally been less severe than before 1980. One reason is improved and accelerated disclosure of information by companies. Another is the increase in reports by market analysts. In general, anything that increases the extent to which information becomes public reduces the tendency of skeptical investors to react to stale information and generate a delayed overreaction.
The overconfidence and skepticism of investors also explains the tendency of stock prices to drift following corporate announcements like profit and revenue surprises, share repurchases and new equity issues. That’s because many investors tend to be skeptical even of the value of information that comes straight from a company, and that skepticism stretches out the effect of the positive news.
If there is a lesson here for investors, it’s that it may pay for them to reconsider their own expertise: Those whose skepticism leads them to sell high-momentum stocks may be leaving money on the table.
Dr. Subrahmanyam is a professor and the Goldyne and Irwin Hearsh chair in money and banking at the Anderson School of Management, University of California, Los Angeles. Dr. Titman is a professor and the McAllister centennial chair in financial service at the McCombs Schools of Business, University of Texas at Austin. They can be reached at reports@wsj.com.
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