European Momentum Strategies, Information Diffusion, and Investor Conservatism

Abstract

In this paper we conduct an out-of-sample test of two behavioral theories that have been proposed to explain momentum in stock returns. We test the gradual-information-diffusion model of Hong and Stein (1999) and the investor conservatism bias model of Barberis, Shleifer and Vishny (1998) in a sample of 13 European stock markets during the period 1988 to 2001. These two models predict that momentum comes from the (i) gradual dissemination of firm-specific information and (ii) investors' failure to update their beliefs sufficiently when they observe new public information. The findings of this study are consistent with the predictions of the behavioral models of Hong and Stein's (1999) and Barberis et al. (1998). The evidence shows that momentum is the result of the gradual diffusion of private information and investors' psychological conservatism reflected on the systematic errors they make in forming earnings expectations by not updating them adequately relative to their prior beliefs and by undervaluing the statistical weight of new information.