Profiting from past winners and losers
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Nauzer Balsara* is an Associate Professor of Finance at Northeastern Illinois University, Chicago. He obtained his PhD in Money and Financial Markets from Columbia University, New York, in 1986.
Lin Zheng is an Assistant Professor of Accounting at Northeastern Illinois University, Chicago. She obtained her PhD in Accounting from the University of Alabama in 2003. *College of Business and Management, Northeastern Illinois University, 5500 North St Louis Avenue, Chicago, IL 60625-4699, USA Tel: ⫹1 (773) 442 6146; Fax: ⫹1 (773) 442 4900; e-mail: [email protected]
Abstract This paper posits that information diffusion is a function of its dissemination and assimilation. Whereas dissemination is proportional to observable factors such as volume and price volatility, assimilation is dependent on unobservable factors such as the usefulness and reliability of information. It is found that buying low-volume (or low-volatility) past losers and shortselling low-volume (or low-volatility) past winners generates a positive net return across the entire sample period and especially during bear markets. In addition, buying high-volatility past winners and shortselling high-volatility past losers generates a positive net return, especially during bear markets. Keywords: information diffusion, momentum profits, trading volume, price volatility
Introduction In recent years, a large volume of empirical work has documented a variety of anomalous return patterns which have confounded the precepts of the Efficient Market Hypothesis (EMH). In particular, several recent papers have documented that stock returns are positively correlated at lags of three to twelve months and display a negative autocorrelation at horizons of one to five years. Return patterns tend to exhibit momentum in the short run, with past winners continuing to perform well, and past
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losers continuing to perform poorly. For example, Jegadeesh and Titman (1993) find that a strategy that buys stocks that have performed in the highest decile over the past six months and simultaneously sells short stocks in the lowest decile over the same time period earns a positive momentum net profit over the next six to twelve months. Similarly, Chan et al. (1996) find that the predictability of future returns from past returns is due to the market’s underreaction to past earnings news. Rouwenhorst (1998) finds a similar
Vol. 6, 5, 329–344
Journal of Asset Management
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pattern of intermediate-term price momentum in 12 countries, suggesting that the results are not due to a data snooping bias. Few explanations have been offered for this intermediate-term momentum effect. For example, Fama and French (1996) show that a three-factor model of returns fails to explain intermediate-term price momentum. More recently, Grundy and Martin (2001) show that momentum effects are not explained by cross-sectional variations in expected returns or industry effects. Given the difficulty that the traditional asset-pricing models
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