Noise in Stock Returns as Natural Experiments: Forward- and Backward-Looking Market-Betas, Momentum, and Reversals

49 Pages Posted: 23 Mar 2009 Last revised: 14 May 2009

See all articles by Gerard Hoberg

Gerard Hoberg

University of Southern California - Marshall School of Business - Finance and Business Economics Department

Ivo Welch

University of California, Los Angeles (UCLA); National Bureau of Economic Research (NBER)

Date Written: May 13, 2009

Abstract

Market-beta, momentum, and 1-month-reversal are statistics computed from historical stock-returns. However, when a stock has experienced unusually noisy rates of return (e.g., a rare extreme stock return), ignoring this noise should yield a better estimate of the future statistic than the actual historical statistic. The standard method to do this, at least in the context of market-betas, is Stein shrinkage (vasicek:1973).

Our paper exploits the wedge between the two statistics: If investors care about the forward-looking aspect of a measure, then it is the shrunk statistic that should predict future stock returns. If investors care about the backward-looking "characteristics" aspect of a measure, then it is the unshrunk actual historical statistic that should predict future stock returns. We find: [1] Market-beta contains a backward-looking aspect that has a negative influence on future stock returns. This distorts the positive signal in the forward-looking (likely hedging-related) aspect of market-beta. [2] 2-to-13 month momentum is principally a forward-looking effect. [3] The 1-month return reversal effect arises principally from some backward-looking characteristic.

Suggested Citation

Hoberg, Gerard and Welch, Ivo, Noise in Stock Returns as Natural Experiments: Forward- and Backward-Looking Market-Betas, Momentum, and Reversals (May 13, 2009). Available at SSRN: https://ssrn.com/abstract=1364745 or http://dx.doi.org/10.2139/ssrn.1364745

Gerard Hoberg

University of Southern California - Marshall School of Business - Finance and Business Economics Department ( email )

Marshall School of Business
Los Angeles, CA 90089
United States

HOME PAGE: http://www-bcf.usc.edu/~hoberg/

Ivo Welch (Contact Author)

University of California, Los Angeles (UCLA) ( email )

110 Westwood Plaza
C519
Los Angeles, CA 90095-1481
United States
310-825-2508 (Phone)

HOME PAGE: http://www.ivo-welch.info

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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