Momentum and reversal in financial markets with persistent heterogeneity

Abstract

This paper investigates whether short-term momentum and long-term reversal may emerge from the wealth reallocation process taking place in speculative markets. We assume that there are two classes of investors who trade long-lived assets by holding constantly rebalanced portfolios based on their beliefs. Provided beliefs, and thus portfolios, are sufficiently diversified, all investors survive in the long-run and, due to waves of mispricing, the resulting equilibrium returns exhibit long-term reversal. If, moreover, asset dividends are positively correlated, investors' profitable trades become positively correlated too, thus generating short-term momentum in equilibrium returns. We use the model to replicate the performance of the Winners and Losers portfolios highlighted by the empirical literature and to provide insights on how to improve upon them. Finally, we show that dividend positive autocorrelation is positively related to momentum and negatively related to reversal while diversity of beliefs is positively related to both momentum and reversal.

Strategically Biased Learning in Market Interactions

“…Highlighting strategic and welfare issues that may occur in economies populated by logarithmic traders, 1 this paper complements the analyses of evolutionary dynamics performed in Dindo (2013, 2014), Giachini (2017, 2019a,b) Bottazzi et al (2018Bottazzi et al ( , 2019, Dindo and Massari (2020), Giachini (2021). Indeed, exploiting the selection results in those contributions, our paper paves the way to further explorations on the link between heuristic behavioral rules, evolutionary dynamics, and strategic choices.…”

Behavioral Equilibrium and Evolutionary Dynamics in Asset Markets: Survival of the Fittest for Portfolio Rules

“…Note that in the model with exogenous asset payo¤s, when R t;k (s t ; ) = R t;k (s t ) does not depend on = ( 1 ; :::; K ), the system of equations (20) reduces to…”

“…Theorem 3 below is a key mathematical tool used in the analysis of the model at hand. It provides a variational characterization of the solution to the fundamental equation (20). We formulate the result in a general form and then apply it to the speci…c model at hand.…”

Market structure or agent rationality: How efficiency trades with belief updating?

“…Gode and Sunder (1993) prove that a double-auction market composed by zero-intelligence agents respecting budget constraints produces efficiency results that match competitive equilibrium allocations. Giachini (2021) shows that, under heterogeneous and incorrect beliefs, the evolutionary market selection forces operating in an economy populated by agents following a simple trading rule (as in Bottazzi et al, 2018Bottazzi et al, , 2019 can generate a pricing performance more in line with efficient (fully rational) levels than the one obtained in an economy where agents intertemporally maximize their utility (as in Sandroni, 2000;Easley, 2006, 2009). In heterogeneous agent models of financial markets, rational traders (fundamentalists) usually act as a price stabilizing force, while chartists tend to destabilize (Hommes, 2006).…”