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Market Efficiency in an Irrational World

  • Kent Daniel
  • Sheridan Titman

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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File URL: http://www.nber.org/papers/w7489.pdf
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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
Date of revision:
Publication status: published as Financial Analyst Journal (1999).
Handle: RePEc:nbr:nberwo:7489
Note: AP
Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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Web page: http://www.nber.org
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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.
  2. Simon Gervais & Terrance Odean, . "Learning To Be Overconfident," Rodney L. White Center for Financial Research Working Papers 5-97, Wharton School Rodney L. White Center for Financial Research.
  3. Lo, Andrew W. (Andrew Wen-Chuan) & MacKinlay, Archie Craig, 1955-., 1989. "When are contrarian profits due to stock market overreaction?," Working papers 3008-89., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  4. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
  5. Kandel, Shmuel & Stambaugh, Robert F, 1996. " On the Predictability of Stock Returns: An Asset-Allocation Perspective," Journal of Finance, American Finance Association, vol. 51(2), pages 385-424, June.
  6. Kent Daniel & David Hirshleifer & Avanidhar Subrahmanyam, 1998. "Investor Psychology and Security Market Under- and Overreactions," Journal of Finance, American Finance Association, vol. 53(6), pages 1839-1885, December.
  7. Terrance Odean, 1998. "Are Investors Reluctant to Realize Their Losses?," Journal of Finance, American Finance Association, vol. 53(5), pages 1775-1798, October.
  8. Hansen, Lars Peter & Jagannathan, Ravi, 1991. "Implications of Security Market Data for Models of Dynamic Economies," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 225-62, April.
  9. Andrei Shleifer & Robert W. Vishny, 1995. "The Limits of Arbitrage," NBER Working Papers 5167, National Bureau of Economic Research, Inc.
  10. K. Rouwenhorst, 1996. "International Momentum Strategies," Yale School of Management Working Papers ysm36, Yale School of Management, revised 01 Feb 2008.
  11. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1988. "The Survival of Noise Traders in Financial Markets," NBER Working Papers 2715, National Bureau of Economic Research, Inc.
  12. Sanford J Grossman & Joseph E Stiglitz, 1997. "On the Impossibility of Informationally Efficient Markets," Levine's Working Paper Archive 1908, David K. Levine.
  13. Barberis, Nicholas & Shleifer, Andrei & Vishny, Robert, 1998. "A model of investor sentiment," Journal of Financial Economics, Elsevier, vol. 49(3), pages 307-343, September.
  14. Merton, Robert C, 1987. " A Simple Model of Capital Market Equilibrium with Incomplete Information," Journal of Finance, American Finance Association, vol. 42(3), pages 483-510, July.
  15. Daniel, Kent, et al, 1997. " Measuring Mutual Fund Performance with Characteristic-Based Benchmarks," Journal of Finance, American Finance Association, vol. 52(3), pages 1035-58, July.
  16. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
  17. Chan, Louis K C & Jegadeesh, Narasimhan & Lakonishok, Josef, 1996. " Momentum Strategies," Journal of Finance, American Finance Association, vol. 51(5), pages 1681-1713, December.
  18. Harrison Hong & Terence Lim & Jeremy C. Stein, 1998. "Bad News Travels Slowly: Size, Analyst Coverage and the Profitability of Momentum Strategies," NBER Working Papers 6553, National Bureau of Economic Research, Inc.
  19. Waldman, Michael, 1994. "Systematic Errors and the Theory of Natural Selection," American Economic Review, American Economic Association, vol. 84(3), pages 482-97, June.
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