Research examines how people’s understanding of the market could make asset returns predictable
It’s an age-old question for investors: when to buy stocks and when to sell them.
While picking the sweet spot may be elusive for many, new research shows how markets gain momentum and how investors can make better decisions based on it.
The study, co-authored by Albert “Pete” Kyle, the Charles E. Smith Chair Professor of Finance at the University of Maryland’s Robert H. Smith School of Business, highlights that if every investor had the same information and thought the same way, they would believe that there was no way to predict the market because stock prices would react to information in the knowledge that all investors will make the same decisions.
But that isn’t how people operate.
Even when investors have the same information, their individual interpretation of, for example past performance, will differ.
“For returns to be predictable based on past prices, you must have what we call positive autocorrelation or negative autocorrelation,” Kyle explained. “Positive autocorrelation says that if a price has been going up in the past, it will likely go up in the future. That says if you want to beat the market, you should be a momentum trader.”
Listen to the noise
Kyle says that most people are momentum traders but over the wrong horizon. He says that being a contrarian traders can make a profit by listening the noise.
“Noise trading tends to make contrarian trading profitable – that is, you sell when the noise traders are buying and pushing the prices up and buy when prices fall as the noise traders liquidate their positions,” he said.
He and his co-authors were interested in how markets can get momentum – to make it profitable to buy stocks as they are going up in price and sell stocks going down.
“People don’t anticipate that that’s what they are doing,” he said. “It comes as a surprise that these noise traders keep on buying and it comes as a surprise that prices keep on going up. People don’t really think that there is momentum, but there is. They don’t understand the market properly.”
Capitalizing on market momentum
So, what can investors do to make the most of market momentum?
“If you buy a stock and it goes up a little bit, you should hang onto it. The momentum might last longer than you think. Don’t take your gains too quickly. Hang on to them and let them ride for a while. On the other hand, there is evidence that you should take your losses quickly, exploiting shorter-term momentum. If you buy a stock and it goes down, then it’s got negative momentum and you should sell it quickly.”
The paper, called “Beliefs Aggregation and Return Predictability” was co-authored by Anna A. Obizhaeva of the New Economic School in Moscow and Yajun Wang of Baruch College, and is conditionally accepted by the Journal of Finance.