Overreaction Evidence from Large-Cap Stocks
Review of Accounting and Finance, Forthcoming
26 Pages Posted: 25 Jul 2014 Last revised: 23 Jun 2015
Date Written: November 13, 2013
Purpose – The purpose of this paper is to assess the performance of a contrarian investment strategy focusing on frequently traded large-cap U.S. stocks. We address previous criticisms that losers’ gains are not due to overreaction but due to their tendency to be thinly traded and smaller-sized firms than winners.
Design/Methodology/Approach – We construct portfolios based on past performance and examine whether contrarian returns exist. We employ the Capital Asset Pricing Model (CAPM), Fama and French three-factor model and the Carhart’s (1996) momentum portfolio to test whether excess returns are feasible in a contrarian strategy.
Findings – The results show an asymmetric performance following portfolio formation. Whereas both, winners and losers portfolios, have gains during holding periods, losers outperform winners at all times, and with a differential of up to 29.2% thirty-six months after portfolio formation. Furthermore, the loser and the winner portfolios’ alphas are significant, suggesting that the CAPM and the multifactor models are unable to explain return differentials between winners and losers. Our evidence supports two main conclusions. First, stock market overreaction still holds for a sample of large firms. Second, this is robust to the Fama and French (1993, 1996) three-factor model and Carhart (1997) momentum portfolio. Our findings emphasize the relevance of a contrarian strategy when rebalancing investment portfolios.
Practical Implications – Portfolio managers can improve stock returns by selling past winners and buying previous loser large-cap U.S. stocks.
Originality/Value – This paper is the first, to the authors' knowledge, to examine frequently traded large cap U.S. stocks in order to avoid infrequent trading and size concerns.
Keywords: Overreaction, CAPM, Stock Market Anomaly, Three-factor model
JEL Classification: G11, G12, G14
Suggested Citation: Suggested Citation