A Parsimonious Model of Momentum and Reversals in Financial Markets
87 Pages Posted: 7 Jul 2017 Last revised: 26 Apr 2019
Date Written: April 11, 2019
We develop a model where overconfident investors overestimate their ability to produce information but are skeptical of others' ability. Skeptical traders that are yet to receive information believe that the informed have learned little. This leads to excess liquidity provision and hence, underreaction and momentum. Skepticism also causes prices to react to stale information, implying overreaction and long-term reversals. Hence, skepticism alone can generate both momentum and reversals; however, reversals are amplified because traders over-assess their signal quality. We explain how long-run reversals can disappear while shorter-term momentum prevails, provide empirical implications, and link momentum to liquidity and informational efficiency.
Keywords: momentum, reversal, cursedness, information trading
JEL Classification: G2, G12, G14
Suggested Citation: Suggested Citation