Examining return predictability of industry style portfolios with prior return relative to a benchmark

Abstract

Abstract This paper investigates the ability of prior returns, relative to aggregate market returns, to predict future returns on industry style portfolios. The results show that past return differential predicts one-month ahead returns negatively, even in the presence of a set of state variables. The predictability is also found to be robust to alternative specifications and estimation methodologies. A possible explanation is related to dynamic loss aversion among investors. More specifically, when combined with the house money effect, prior relative performance has inverse relationship with degree of loss aversion leading to predictability in the next period returns.