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Market Efficiency in an Irrational World

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  • Kent Daniel
  • Sheridan Titman

Abstract

This paper explains why investors are likely to be overconfident and how this behavioral bias affects investment decisions. Our analysis suggests that investor overconfidence can potentially generate stock return momentum and that this momentum effect is likely to be the strongest in those stocks whose valuation requires the interpretation of ambiguous information. Consistent with this, we find that momentum effects are stronger for growth stocks than value stocks. A portfolio strategy based on this hypothesis generates strong abnormal returns that do not appear to be attributable to risk. Although these results violate the traditional efficient markets hypothesis, they do not necessarily imply that rational but uniformed investors, without the benefit of hindsight, could have actually achieved the returns. We argue that to examine whether unexploited profit opportunities exist, one must test for what we call adaptive-efficiency, which is a somewhat weaker form of market efficiency that allows for the appearance of profit opportunities in historical data, but requires these profit opportunities to dissipate when they become apparent. Our tests reject this notion of adaptive-efficiency.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7489.

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Date of creation: Jan 2000
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Publication status: published as Financial Analyst Journal (1999).
Handle: RePEc:nbr:nberwo:7489

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  1. Harrison Hong & Jeremy C. Stein, 1997. "A Unified Theory of Underreaction, Momentum Trading and Overreaction in Asset Markets," NBER Working Papers 6324, National Bureau of Economic Research, Inc.
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  13. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, American Finance Association, vol. 52(1), pages 57-82, March.
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  17. Kent Daniel & David Hirshleifer & Avanidhar Subrahmanyam, 1998. "Investor Psychology and Security Market Under- and Overreactions," Journal of Finance, American Finance Association, American Finance Association, vol. 53(6), pages 1839-1885, December.
  18. K. Rouwenhorst, 1996. "International Momentum Strategies," Yale School of Management Working Papers, Yale School of Management ysm36, Yale School of Management, revised 01 Feb 2008.
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Citations

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Cited by:
  1. Alexander S. Sangare, 2005. "Efficience des marchés : un siècle après Bachelier," Revue d'Économie Financière, Programme National Persée, Programme National Persée, vol. 81(4), pages 107-132.
  2. Emmanuel PETIT (GREThA UMR CNRS 5113), 2010. "The role of regret in the persistence of anomalies in financial markets (In French)," Cahiers du GREThA, Groupe de Recherche en Economie Théorique et Appliquée 2010-07, Groupe de Recherche en Economie Théorique et Appliquée.
  3. Schulmeister, Stephan, 2006. "The interaction between technical currency trading and exchange rate fluctuations," Finance Research Letters, Elsevier, Elsevier, vol. 3(3), pages 212-233, September.
  4. Roman Kraeussl & Christian Wiehenkamp, 2012. "A call on art investments," Review of Derivatives Research, Springer, Springer, vol. 15(1), pages 1-23, April.
  5. Rodolfo Apreda, 2000. "Differential Rates of Return and Residual Information Sets (A Discrete Approach)," CEMA Working Papers: Serie Documentos de Trabajo. 177, Universidad del CEMA.
  6. Qin Xiao & Randolph Gee Kwang Tan, 2006. "Signal Extraction with Kalman Filter: A Study of the Hong Kong Property Price Bubbles," Economic Growth centre Working Paper Series, Nanyang Technolgical University, School of Humanities and Social Sciences, Economic Growth centre 0601, Nanyang Technolgical University, School of Humanities and Social Sciences, Economic Growth centre.
  7. Stephan Schulmeister, 2007. "The Interaction Between the Aggregate Behaviour of Technical Trading Systems and Stock Price Dynamics," WIFO Working Papers, WIFO 290, WIFO.

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