FINC3017 Investments and Portfolio Management

Essay: Market Efficiency and Anomalies

Topic:Stock price momentum: Jegadeesh and Titman (1993)

Momentum anomaly and EMH

Anomaly is a stock return deviation that challenge efficient market hypothesis (EMH). Jegadeesh and Titman (1993) theorise price momentum anomaly in the stock market for the first time. It contradicted to efficient market hypothesis thereby is widely debated. EMH states that no consistent excess return can be achieved since security prices fully reflect all available information (Fama 1970). Therefore, future prices cannot be predicted through technical analysis of past prices. If the hypothesis is true, passive investment strategy ought to be taken, because it is impossible to get abnormal return by aggressive trading.

However, Jegadeesh and Titman show that stocks performed well over the previous 3 to 12 months tend to continue to perform well over 3 to 12 months holding periods. Buy past winners and short past losers earned statistically significant positive return of averaging 12.01% per year. Predictable price patterns and excess returns contradict the efficient market hypothesis. Investors and fund managers perform actively in pursuing abnormal profits.

Literature review and the reason of anomaly

A large number of literatures illustrate that momentum anomaly exist. Some important literatures are Chan, Jegadeesh and Lakonishok (1996), Conrad and Kaul (1998) and Moskowitz and Grinblatt (1999). Lee and Swaminathan (2000) find high past turnover stocks exhibit larger magnitude of momentum but shorter persistence of momentum. Grundy and Martin (2001) study of the US market 1926 – 1995 found that after adjusting for dynamic risks, there are stable momentum profits. However, Carhart (1997), Brooks and Miffre (2007) believe if take transaction costs into account, there will be no persistence performance of superior stocks. But underperformance will remain worse. Grundy and Martin (2001) show that round-trip cost above 1.5% makes the anomaly unprofitable.

It is difficult to explain price momentum use traditional risk-return model (Fama and French (1996), Grundy and Martin (2001)). But, momentum anomaly exists for reasons. The underlying mechanism of the anomaly can be explained from the perspective of behavioural finance and Knightian uncertainty. Both underreaction and delayed overreaction to the information can cause price momentum.

Barberis, Schleifer and Vishny (1998) show that because of conservatism (Edwards 1968), investors tend to underweighting new information at the beginning. Information slowly spread and slowly incorporates into share price. Therefore,

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