Behavioural Finance: A New Paradigm to Explain Momentum Effect

Abstract

During the 1970’s, the standard finance theory of market efficiency became the model of market behaviour accepted by the majority of academicians. Fama (1970,1991) demonstrated that in securities market, populated by well informed investors, investment will be appropriately priced and will reflect all available information. However, there came a strong blow to the hypothesis when Jegadeesh and Titman (1993) argued that there exists evidence that momentum investing strategies provide abnormal returns in different stock markets. Since then it has become one of the grey areas in finance and lead to an on-going debate on its existence. In the search for an explanation for the profitability of momentum strategies, the literature has not come to a consensus. Several authors suggested rational-based approach where momentum profits represents a compensation for risk while others proposed behavioural models to explain momentum anomaly in which momentum returns result from a sequential process of investor’s reactions to news. The current paper evaluates the work of various authors discussing the possible causes of the effect emphasizing the various behavioural based explanations. Since behavioural finance is in its initial stage, the paper will adds to the literature on the same.