A simulation and analysis of the overreaction hypothesis market anomaly as an investment strategy for individual and hedge fund investors
LoGrasso, Marc Francis
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This study revisited the overreaction hypothesis studied by DeBondt and Thaler (1985) to determine its suitability as a strategy for private investment. Using their same filters from January 1986 through January 2004, prior NYSE losers only outperformed prior NYSE winners by 0.02% over the subsequent three years. The inclusion of AMEX and NASDAQ stocks resulted in a cumulative abnormal return differential of 28.60%; this difference increased to 34.85% when the requirement of preexisting data was reduced from seven years to five years. Qualitatively similar results were found when the analysis shifted from looking at cumulative abnormal returns to looking at buy-and-hold returns. While the buy-and-hold return results faced significant exposure to market, size, book-to-market, and momentum-based risk, the explanatory power of models incorporating these factors was relatively low (maximum 13.82%), and there still existed significant risk-adjusted returns as determined by the intercept of the regressions of up to 0.824% per month. Additionally, breaking down the factor analysis to be run on the losers and winners separately showed that both losers and winners experienced reversals in their returns and that these reversals were stronger in the winners than the losers. An investor looking to exploit these return differences could earn up to 51.44% over a three-year period, 23.22% of which would be considered risk-adjusted return, by using the maximum amount of leverage allowed by Regulation T. If this investor desires to instead invest in a hypothetical hedge fund following this same strategy, he could still earn 32.54% over three years, 11.52% of which would be risk-adjusted, while the hedge fund manager extracts 17.92% of the initial investment over the same three-year period in the form of management and performance fees. While the institutional constraints in place designed to protect investors who engage in the type of short selling required to implement this strategy succeed in reducing the investor's general exposure to various risk factors, the legal use of maximum leverage actually eliminates most of the risk-reducing benefits of these constraints without providing compensation in the form of additional returns (either on a raw or risk-adjusted basis). Even though the initial study was published in 1985, there is little evidence that arbitrageurs have reduced the difference in the returns between prior losers and winners. There also appears to be a pronounced January effect in the returns to investing by this strategy. Finally, there is no indication of the extent to which this strategy is followed in practice.