Over or Under? Momentum, Idiosyncratic Volatility and Overreaction

Abstract

Several studies have attributed the high excess returns of the momentum strategy in the equity market to investor behavioral biases. However, whether momentum effects occur because of investor underreaction or because of investor overreaction remains a question. Using a simple model to illustrate the linkage between idiosyncratic volatility and investor overreaction as well as the stock turnover as another measure of overreaction, I present evidence that supports the investor overreaction explanation as the source of momentum effects. Furthermore, I show that when investor overreaction is low, momentum effects are more due to industries (industry momentum) rather than stocks.