Noise, Beliefs, and Momentum

Abstract

We show in a simple framework that momentum trading can exist in equilibrium and momentum trading is profitable. Properties of the model fit the empirics well. First, the model captures in a parsimonious manner both short-term overreaction and long-term reversals. Second, it predicts that momentum and long-term reversals should be observed in any market where there is noise. Thus, the model gives theoretical support to the empirical evidence that these anomalies are not artifacts of data snooping and to the extant empirical evidence that these anomalies are pervasive. Momentum traders observe noise shocks and trade on it as information. This trading incorporates a predictive role to the noise. That is, if agents believe a past price change to be informative of future price change and act on this belief, it will be true and trading on this belief will be profitable. Thus, momentum trading is a self-fulfilling action.

Keywords: Noise, Momentum, Self, Prophecy, Belief, Price formation, Returns, Reversals, Risk, Limited

JEL Classification: C32, C61, C62, D40, D81, D84, E17, E31, G11, G12, G14