What Makes Investors Overreact in the Short Run?

Abstract

This paper analyzes how return consistency of a security affects future returns for short horizons. The primary hypothesis is that securities with consistently positive returns are perceived to be riskier, since an investor with diffuse priors regarding the distribution of positive and negative information presumes that most of the favorable information has been released. These perceptions lead to clear predictions for short-horizon returns, which should be higher for stocks with negative consistency and lower for stocks with positive consistency. It is found that stocks with 6 - 12 days of consistently positive or negative returns show strong return predictability over 1 - 4 week investment periods. Positive consistency leads to lower returns than other stocks, while negative consistency leads to abnormally high returns. It is also found that short-term momentum reversals do not exist without consistency, but consistency effects continue to exist without momentum. Controlling for firm size, momentum and liquidity measures, longer periods of consistency lead to more profitable consistency-based trading strategies. Although consistency is clearly distinct from momentum, there is a strong interaction between the two effects, and portfolios formed on both criteria are highly profitable. During the month of January, this interaction is magnified, implying that past return consistency may be a subjective mitigating factor for information asymmetry issues in equity markets. High share turnover serves to exaggerate consistency effects over short horizons. These results have implications regarding how there may be path dependence in the formation of expected returns in noisy equity markets.