Cumulative Prospect Theory, Myopic Loss Aversion and Momentum Crashes
35 Pages Posted: 22 Aug 2014
Date Written: August 22, 2014
Momentum strategies generate significant positive returns over long investment horizons; however these strategies experience infrequent periods of large negative returns. These periods are known as 'momentum crashes'. We demonstrate that the probability of a momentum crash is time-varying, increasing following periods of high market return dispersion, a proxy for a change in the market state. Under cumulative prospect theory, investors overweight the probability of a momentum crash when estimating their value function, discounting the current price of "winners" relative to "losers" resulting in positive expected future returns for the momentum strategy. Consistent with this theory, we show that momentum returns are substantially lower and volatility is higher in regimes where the probability of a momentum crash is high. Although momentum crashes are predictable they may not be exploited by institutional investors. Therefore, we argue that the negative (positive) skewness of the return distribution of winner (loser) portfolios is priced and may partly explain the momentum premium.
Keywords: Momentum crash, skewness, cumulative prospect theory, regime switching
JEL Classification: G11, G12
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