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Momentum Trading, Return Chasing, and Predictable Crashes

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  • Chabot, Benjamin
  • Ghysels, Eric
  • Jagannathan, Ravi

Abstract

We combine self-collected historical data from 1867 to 1907 with CRSP data from 1926 to 2012, to examine over 140 years of risk and return of one of the most popular mechanical trading strategies—momentum. We find that the momentum strategy has earned abnormally high risk-adjusted returns—a three factor alpha of 1 percent per month between 1927 and 2012 and 0.5 percent per month between 1867 and 1907—both statistically significantly different from zero. However, the momentum strategy also exposed investors to large losses (crashes) during both periods. Momentum crashes were predictable. Crashes were more likely when momentum had recently performed well (both eras), interest rates were relatively low (1867–1907), or momentum had recently outperformed the stock market (CRSP era) - times when borrowing or attracting return chasing “blind capital” would have been easier. We argue based on a stylized model and simulated outcomes from a richer model that a money manager who competes for funds from return-chasing investors and is compensated via fees that are convex in the amount of money managed and the return on that money has an incentive to remain invested in momentum even when the crash risk is known to be high.

Suggested Citation

  • Chabot, Benjamin & Ghysels, Eric & Jagannathan, Ravi, 2014. "Momentum Trading, Return Chasing, and Predictable Crashes," CEPR Discussion Papers 10234, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:10234
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    Cited by:

    1. Caroline Fohlin & Thomas Gehrig & Marlene Haas, 2015. "Rumors and Runs in Opaque Markets: Evidence from the Panic of 1907," Emory Economics 1503, Department of Economics, Emory University (Atlanta).
    2. Kuk Mo Jung, 2017. "Liquidity Risk And Time-Varying Correlation Between Equity And Currency Returns," Economic Inquiry, Western Economic Association International, vol. 55(2), pages 898-919, April.
    3. Gino Cenedese & Richard Payne & Lucio Sarno & Giorgio Valente, 2016. "What Do Stock Markets Tell Us about Exchange Rates?," Review of Finance, European Finance Association, vol. 20(3), pages 1045-1080.
    4. Victoria Dobrynskaya, 2017. "Dynamic Momentum and Contrarian Trading," HSE Working papers WP BRP 61/FE/2017, National Research University Higher School of Economics.
    5. repec:eee:riibaf:v:45:y:2018:i:c:p:233-242 is not listed on IDEAS

    More about this item

    Keywords

    Limits-to-arbitrage; Momentum;

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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