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Momentum and Reversal in Financial Markets with Persistent Heterogeneity

Giulio Bottazzi (), Pietro Dindo () and Daniele Giachini
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Daniele Giachini: Department of Economics, Scuola Superiore Sant'Anna, Pisa

No 2018:03, Working Papers from Department of Economics, University of Venice "Ca' Foscari"

Abstract: This paper investigates whether short-term momentum and long-term reversal may emerge from the wealth reallocation process taking place in speculative markets. We assume that there are two classes of investors who trade long-lived assets by holding constantly rebalanced portfolios based on their beliefs. Provided beliefs, and thus portfolios, are sufficiently diversified, all investors survive in the long-run and, due to waves of mispricing, the resulting equilibrium returns exhibit long-term reversal. If, moreover, asset dividends are positively correlated, investors’ profitable trades become positively correlated too, thus generating short-term momentum in equilibrium returns. We use the model to replicate the performance of the Winners and Losers portfolios highlighted by the empirical literature and to provide insights on how to improve upon them. Finally, we show that dividend positive autocorrelation is positively related to momentum and negatively related to reversal while diversity of beliefs is positively related to both momentum and reversal.

Keywords: Market Efficiency; Heterogeneous Beliefs; Speculation; Short-term Momentum; Long-term Reversal (search for similar items in EconPapers)
JEL-codes: C60 D53 G02 G12 G14 (search for similar items in EconPapers)
Date: 2018
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