When are Contrarian Profits Due to Stock Market Overreaction?

41 Pages Posted: 27 Apr 2000  

Andrew W. Lo

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER); Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)

A. Craig Mackinlay

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Date Written: May 1989

Abstract

The profitability of contrarian investment strategies need not be the result of stock market overreaction. Even if returns on individual securities are temporally independent, portfolio strategies that attempt to exploit return reversals may still earn positive expected profits. This is due to the effects of cross-autocovariances from which contrarian strategies inadvertently benefit. We provide an informal taxonomy of return-generating processes that yield positive [and negative] expected profits under a particular contrarian portfolio strategy, and use this taxonomy to reconcile the empirical findings of weak negative autocorrelation for returns on individual stocks with the strong positive autocorrelation of portfolio returns. We present empirical evidence against overreaction as the primary source of contrarian profits, and show the presence of important lead-lag relations across securities.

Suggested Citation

Lo, Andrew W. and Mackinlay, A. Craig, When are Contrarian Profits Due to Stock Market Overreaction? (May 1989). NBER Working Paper No. w2977. Available at SSRN: https://ssrn.com/abstract=227214

Andrew W. Lo (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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National Bureau of Economic Research (NBER) ( email )

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Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)

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Archie Craig MacKinlay

University of Pennsylvania - Finance Department ( email )

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National Bureau of Economic Research (NBER)

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