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Over or Under? Momentum, Idiosyncratic Volatility and Overreaction | Explained

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “Over or Under? Momentum, Idiosyncratic Volatility and Overreaction” by Mahdi Heidari of Stockholm School of Economics investigates the impact of investor behavioral biases on high excess returns of the momentum strategy in equity markets.

The central question posed is whether momentum effects arise due to investor underreaction or overreaction. By utilizing a simple model, Heidari explores the connection between idiosyncratic volatility and investor overreaction, as well as stock turnover as an alternative measure of overreaction. The findings support the investor overreaction explanation as the primary source of momentum effects.

Moreover, the study demonstrates that when investor overreaction is minimal, industry momentum has a more significant influence on momentum effects than individual stocks.

Abstract Of Paper

Several studies have attributed the high excess returns of the momentum strategy in the equity market to investor behavioral biases. However, whether momentum effects occur because of investor underreaction or because of investor overreaction remains a question. Using a simple model to illustrate the linkage between idiosyncratic volatility and investor overreaction as well as the stock turnover as another measure of overreaction, I present evidence that supports the investor overreaction explanation as the source of momentum effects. Furthermore, I show that when investor overreaction is low, momentum effects are more due to industries (industry momentum) rather than stocks.

Original paper – Download PDF

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Author

Mahdi Heidari
Stockholm School of Economics

Conclusion

In conclusion, Mahdi Heidari’s research paper “Over or Under? Momentum, Idiosyncratic Volatility and Overreaction” provides valuable insight into the role of investor behavioral biases in the excess returns of the momentum strategy within equity markets.

Through a simple model, the study establishes a link between idiosyncratic volatility, investor overreaction, and stock turnover as measures of overreaction. The findings presented endorse investor overreaction as the primary source of momentum effects, clarifying the debate on the impact of underreaction versus overreaction.

Additionally, the research reveals that industry momentum plays a more significant role in driving momentum effects when investor overreaction is minimized, further elucidating the dynamics behind momentum strategies in the equity market.

Related Reading:

Short-term Momentum

Trend Salience, Investor Behaviors and Momentum Profitability

FAQ

What is the central question addressed in Mahdi Heidari’s research paper, and what does it contribute to understanding momentum effects in equity markets?

Mahdi Heidari’s research paper investigates the root cause of high excess returns in the momentum strategy within equity markets. The central question is whether momentum effects result from investor underreaction or overreaction. The paper explores this by employing a simple model that examines the relationship between idiosyncratic volatility, stock turnover, and investor overreaction. The findings contribute to a deeper understanding of the behavioral biases impacting momentum strategies.

What evidence does the paper provide in support of the investor overreaction explanation for momentum effects, and how does it link idiosyncratic volatility and stock turnover to this explanation?

The paper presents evidence supporting the idea that investor overreaction is the primary source of momentum effects. It establishes a linkage between idiosyncratic volatility and investor overreaction, as well as stock turnover as an alternative measure of overreaction. The study uses these measures to strengthen the case for investor overreaction as the driving force behind the observed momentum effects in equity markets.

How does Mahdi Heidari’s research shed light on the role of industry momentum in driving momentum effects, and under what conditions does it play a more significant role than individual stocks?

The research paper reveals that, when investor overreaction is minimal, industry momentum has a more substantial influence on momentum effects than individual stocks. This insight provides a nuanced understanding of the dynamics behind momentum strategies in equity markets. By highlighting the conditions under which industry momentum becomes more influential, the study contributes to a comprehensive view of the factors driving momentum effects and the interplay between investor behavior and market trends.

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