Rebels, Conformists, Contrarians And Momentum Traders

Abstract:     
We consider investing in a noisy market with incorrect beliefs about predictability. Two types of agents use subjective models to optimize their portfolios - "conformists" who happen to believe in the self-fulfilling market consensus and "rebels" who have wrong beliefs. We compare the agents' dynamic trading and their empirically observable investment performance. An agent who believes in log-normality is always a contrarian trader, who buys more shares after the price goes down, and sells shares when the price goes up. In contrast, an agent who believes in price predictability acts as a momentum trader, who buys more shares after the price goes up, for a range of subjective market mis-pricings. We show that more incorrect beliefs about predictability can lead to higher expected returns. Moreover, rebels with incorrect beliefs can have higher expected return than conformists with the same risk-aversion. We find that it is more dangerous to be a sophisticated rebel in a non-predictable world, than to be a simplistic rebel in a predictable world.

Number of Pages in PDF File: 45

JEL Classification: G11

working papers series