A Parsimonious Model of Momentum and Reversals in Financial Markets

87 Pages Posted: 7 Jul 2017 Last revised: 26 Apr 2019

See all articles by Jiang Luo

Jiang Luo

Nanyang Technological University (NTU) - Division of Banking & Finance

Avanidhar Subrahmanyam

University of California, Los Angeles (UCLA) - Finance Area; Institute of Global Finance, UNSW Business School; Financial Research Network (FIRN)

Sheridan Titman

University of Texas at Austin - Department of Finance; National Bureau of Economic Research (NBER)

Date Written: April 11, 2019

Abstract

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

Luo, Jiang and Subrahmanyam, Avanidhar and Titman, Sheridan, A Parsimonious Model of Momentum and Reversals in Financial Markets (April 11, 2019). Available at SSRN: https://ssrn.com/abstract=2997001 or http://dx.doi.org/10.2139/ssrn.2997001

Jiang Luo

Nanyang Technological University (NTU) - Division of Banking & Finance ( email )

S3-01C-75 50 Nanyang Avenue
Singapore, 639798
Singapore

Avanidhar Subrahmanyam (Contact Author)

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-5355 (Phone)
310-206-5455 (Fax)

Institute of Global Finance, UNSW Business School

Sydney, NSW 2052
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

Sheridan Titman

University of Texas at Austin - Department of Finance ( email )

Red McCombs School of Business
Austin, TX 78712
United States
512-232-2787 (Phone)
512-471-5073 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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