Momentum And Reversal Essay

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Two of the most prominent financial-market anomalies are momentum and reversal. Momentum is the tendency of assets with good (bad) recent performance to continue over performing (underperforming) in the near future. Reversal concerns predictability based on a longer performance history: assets that performed well (poorly) over a long period tend to subsequently underperform (over perform). Closely related to reversal is the value effect, whereby the ratio of an asset’s price relative to book value is negatively related to subsequent performance.
Momentum and reversal are viewed as anomalies because they are hard to explain within the standard asset-pricing paradigm with rational agents and frictionless markets. The prevalent explanations of
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Investment funds holding these assets realize low returns, triggering outflows by investors who update negatively about the efficiency of the managers running these funds. As a consequence of the outflows, funds sell assets they own, and this depresses further the prices of the assets hit by the original shock. Momentum arises if the outflows are gradual, and if they trigger a gradual price decline and a drop in expected returns. Reversal arises because outflows push prices below fundamental values, and so expected returns eventually rise. Gradual outflows can be the consequence of investor inertia or institutional constraints.

What is a 'Reversal'

A change in the direction of a price trend. On a price chart, reversals undergo a recognizable change in the price structure. An uptrend, which is a series of higher highs and higher lows, reverses into a downtrend by changing to a series of lower highs and lower lows. A downtrend, which is a series of lower highs and lower lows, reverses into an uptrend by changing to a series of higher highs and higher lows.

Also referred to as a "trend reversal", "rally" or "correction". Price Momentum
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Oftentimes, participants in the stock market predictably overreact to new information, creating a larger-than-appropriate effect on a security's price. Furthermore, it also appears that this price surge is not a permanent trend - although the price change is usually sudden and sizable, the surge erodes over time.

Winners and Losers

In 1985, behavioral finance academics Werner De Bondt and Richard Thaler released a study in the Journal of Finance called "Does the Market Overreact?" In this study, the two examined returns on the New York Stock Exchange for a three-year period. From these stocks, they separated the best 35 performing stocks into a "winner’s portfolio" and the worst 35 performing stocks were then added to a "losers portfolio". De Bondt and Thaler then tracked each portfolio's performance against a representative market index for three years.

Surprisingly, it was found that the loser’s portfolio consistently beat the market index, while the winners portfolio consistently underperformed. In total, the cumulative difference between the two portfolios was almost 25% during the three-year time span. In other words, it appears that the original "winners" would became "losers", and vice

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