Memory-induced Cross-stock Extrapolation in China

Abstract

We propose a similarity criterion for stocks based on their Euclidean distance over a set of attention-related variables to capture investors' memory of stocks. We find that the average past return of similar-attention stocks exhibits a significantly strong, negative predictive power for the future return of a focal stock, suggesting a cross-stock reversal effect. A long-short strategy based on this cross-stock reversal generates a monthly return of 2.23% and an annualized Sharpe ratio of 1.63. This effect cannot be explained by common factors, including short-term reversal. We further demonstrate that the cross-stock reversal effect stems from investors' memory-based belief and irrational cross-extrapolating trading. The predictability is related to the investor clientele since it appears in markets with more retail investors. 

Keywords: Memory, Cross-stock predictability, Extrapolation, Reversal, Attention

JEL Classification: G11, G12, G14