Do Investors Care About Negative Returns?

Abstract

In this paper, we analyse the impact of negative return frequency and the recency bias on future stock market returns. Specifically, we propose a strategy that is based on counting of daily negative returns during the previous month, where investors earn 11.9% p.a. using exponentially-weighted daily returns. Our results show that the exponentially-weighted strategy outperforms the equally-weighted strategy and is robust to a range of existing risk factors and the firms’ characteristics, suggesting that the most recent observations during the month receive more investors’ attention and are the most relevant for future performance. The exponentially weighted strategy remains significant for stocks in S&P 500 after transaction costs. Although the return of the exponentially-weighted strategy is positive for stocks held by institutional and retail investors, it is the highest for stocks that are largely held by retail traders.

Keywords: Stock returns, return predictability, asset management, behavioural asset pricing, recency bias, hot-hand fallacy, binary bias

JEL Classification: G11, G12, G40