An Alternative Behavioral Explanation for the MAX Effect
58 Pages Posted: 4 Aug 2018 Last revised: 1 Aug 2019
Date Written: April 4, 2019
Stocks with high maximum daily returns in the previous month (MAX) yield low future returns. We examine the underlying sources of this MAX effect and present three empirical arguments that question the common presumption that investors with lottery preferences cause an overvaluation of high-MAX stocks. First, high-MAX stocks are comparably unattractive for investors with cumulative prospect theory preferences. Second, we find no price pressure from lottery investors after high-MAX observations but immediate price reversals. Hence, the MAX return itself seems to be the source of the overvaluation. Third, the MAX effect reverses if the MAX return can be linked to an earnings announcement. These findings are perfectly in line with a behavioral phenomenon called strength-weight bias: Investors usually overreact towards extreme high-strength news such that high-MAX stocks tend to be overvalued. However, they under-react if the MAX return is accompanied by reliable high-weight news such as earnings announcements.
Keywords: MAX Effect, Lottery Preferences, Strength-Weight Bias, Cross-Sectional Return Predictability
JEL Classification: G12, G14, G40
Suggested Citation: Suggested Citation