Working Paper: NBER ID: w2977
Authors: Andrew W. Lo; Craig Mackinlay
Abstract: The profitability of contrarian investment strategies need not be the result of stock market overreaction. Even if returns on individual securities are temporally independent, portfolio strategies that attempt to exploit return reversals may still earn positive expected profits. This is due to the effects of cross-autocovariances from which contrarian strategies inadvertently benefit. We provide an informal taxonomy of return-generating processes that yield positive [and negative] expected profits under a particular contrarian portfolio strategy, and use this taxonomy to reconcile the empirical findings of weak negative autocorrelation for returns on individual stocks with the strong positive autocorrelation of portfolio returns. We present empirical evidence against overreaction as the primary source of contrarian profits, and show the presence of important lead-lag relations across securities.
Keywords: contrarian profits; stock market overreaction; investment strategies; autocorrelation
JEL Codes: G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Profitability of contrarian strategies (G41) | Stock market overreaction (G41) |
| Negative autocorrelation in individual stock returns (C22) | Contrarian profits (G40) |
| Positive cross-autocorrelations (C22) | Profitability of contrarian strategies (G41) |
| Lead-lag relationships among securities (G12) | Positive expected profits from contrarian strategies (G41) |
| Cross-autocovariance effects among securities (C10) | Profitability of contrarian strategies (G41) |
| Negative autocorrelation in individual stock returns (C22) | Positive index autocorrelation (C22) |