When Are Contrarian Profits Due to Stock Market Overreaction?
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What they found
Short-term contrarian strategies (buy last week's losers, sell last week's winners) were known to be profitable, and the usual explanation was overreaction. Lo and MacKinlay decomposed those profits and showed that a large share comes not from each stock overreacting but from lead-lag effects: large stocks' returns predict small stocks' returns with a delay, so a contrarian portfolio is implicitly betting that laggards catch up. A sizeable part of weekly contrarian profits therefore reflects slow information diffusion, not investor overreaction.
What you can use
- Short-term reversal profits are partly a liquidity and slow-diffusion effect, not evidence that traders are 'irrational'.
- Because the profits are concentrated in small, illiquid names, they are hard to capture after spreads.
- Big stocks lead, small stocks follow: a structural feature worth understanding for anyone trading small caps.
Caveats
Weekly data 1962 to 1987; lead-lag effects have weakened with electronic markets. Gross of costs. Mathematical.
Tags: mean-reversion, short-term-reversal, lead-lag, liquidity
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.