Cognitive dissonance, sentiment and momentum
Doukas, John A.
Journal of Financial and Quantitative Analysis
Cambridge University Press
We consider whether sentiment affects the profitability of momentum strategies. We hypothesize that news that contradicts investors' sentiment causes cognitive dissonance, slowing the diffusion of such news. Thus, losers (winners) become underpriced under optimism (pessimism). Short-selling constraints may impede arbitraging of losers and thus strengthen momentum during optimistic periods. Supporting this notion, we empirically show that momentum profits arise only under optimism. An analysis of net order flows from small and large trades indicates that small investors are slow to sell losers during optimistic periods. Momentum based hedge portfolios formed during optimistic periods experience long-run reversals.
Author's pre-print version dated May 2011 deposited in SSRN archive. Final version published by Cambridge University Press; available online at http://journals.cambridge.org/
Accepted Manuscripts February 2013, pp 1-74