(March 14, 2012) — Behavioral investment strategy is important, with momentum investment tending to work better in periods longer than six months, a recently published paper asserts.
The paper titled “Behavioral Investment Strategy Matters: A Statistical Arbitrage Approach” notes that momentum strategies — derived from buying stocks or other securities that have had high returns over the past three to twelve months — work only during a longer time-horizon.
According to the paper — co-authored by David S. Sun of Kainan University, Shih-Chuan Tsai of National Taiwan Normal University, and Wei Wang from the School of Economics – Jhe Jiang University — disposition and over-confidence effects are important factors contributing to the phenomenon. The paper employed the concept of statistical arbitrage — techniques designed to profit from pricing inefficiencies between securities — to analyze the momentum phenomenon in the Taiwan market.
The paper continues: “The over-confidence effect seems to dominate the disposition effect, especially in an up market,” explaining the tendency for investors to hold on to losing stocks for too long and sell winning stocks too soon.
Furthermore, the authors assert that the over-confidence investment behavior of institutional investors is the main cause for momentum returns observed in an up market. “In a down market, the institutional investors tend to adopt a contrarian strategy while the individuals are still maintaining momentum behavior within shorter periods,” the paper claims. “The behavior difference between investor groups explains in part why momentum strategies work differently between up and down market states.”
Research into the implications of momentum investing helps investors better understand trading behavior especially in the emerging markets, the authors conclude.
Click here to download the full paper.
This recently published research into behavioral investing strategy jibes with another paper titled “Investors Behaving Badly: Endowment Effect” on the endowment effect. The cognitive tendency among investors to get caught up in the endowment effect — a mental roadblock that can cause investors to hold onto something too long — applies to shares, bonds, and funds in a portfolio, the paper by Morningstar concluded.
“We’re trying to raise awareness about the type of research in the behavioral economics field,” the article’s author Lee Davidson, an ETF analyst with Morningstar, told aiCIO, adding that the aim of studying the field is to raise investor awareness, highlighting the tendance among investors to hold onto losing investments longer than they should.
The danger then, among investors, is that they fail to evaluate securities on a level playing field, failing to focus on the question that actually matters: How will my investments perform in the future? “We naturally exhibit a tendency to be lenient on evaluating the performance of what we own. If the market says our stock is worth £10, we naturally think its worth more even before we perform any analysis whatsoever. Not surprisingly, this cognitive bias does us a disservice,” the report stated.
The report continued: “For every type of investor, therefore, it is important to be cognizant of the endowment effect and judge the various products impartially as best as possible, especially when you already own one or more of them.”