Left-Tail Momentum: Underreaction to Bad News, Costly Arbitrage and Equity Returns

Abstract

This paper documents a significantly negative cross-sectional relation between left-tail risk and future returns on individual stocks trading in the U.S. and international countries. We provide a behavioral explanation to this anomaly based on the idea that investors underestimate the persistence in left-tail risk and overprice stocks with large recent losses. Thus, low returns in the left-tail of the distribution persist into the future causing left-tail return momentum. We find that the left-tail risk anomaly is stronger for stocks that are more likely to be held by retail investors, that receive less investor attention and that are costlier to arbitrage.

Keywords: left-tail risk, momentum, equity returns, retail investors, costly arbitrage, investor inattention

JEL Classification: G10, G11, G12