Momentum and Reversals when Overconfident Investors Underestimate Their Competition
Review of Financial Studies, Forthcoming
63 Pages Posted: 7 Jul 2017 Last revised: 22 Dec 2019
Date Written: April 11, 2019
We develop a model where overconfident investors overestimate their own signal quality but are skeptical of others’. Those investors who are initially uninformed believe that the early informed have learned little, leading the former investors to provide excess liquidity, which, in turn, causes underreaction and short-run momentum. Skeptical investors can also react to stale information, causing momentum, followed by reversals. Hence, skepticism generates both momentum and reversals; the latter are amplified if investors over-assess their own signal precision. We explain how long-run reversals can disappear while shorter-term momentum prevails, provide empirical implications, and link momentum to liquidity and price efficiency.
Keywords: momentum, reversal, cursedness, information trading
JEL Classification: G2, G12, G14
Suggested Citation: Suggested Citation