Trend salience, investor behaviours and momentum profitability

Abstract

Trend extrapolation in financial markets has been well documented, however it is contentious as to which trends will be extrapolated or mean reverted. This paper examines whether investors are more likely to extrapolate trends that they perceive to be salient, thereby providing an empirical test of the behavioural models of momentum. We employ an investment strategy that exploits trend salience by considering both the magnitude and the persistence of recent return performance. Consistent with behavioural models of momentum, an investment strategy based on trend salience significantly outperforms traditional momentum strategies and is not explained by the four-factor model. The relative performance of the trend salience signal is robust across different investment horizons and size-sorted portfolios, although is time-varying; the strategy does not outperform momentum in “down” markets or periods of high volatility in the formation period where trends are more difficult to identify.