Returns to Buying Winners and Selling Losers : Implications for Stock Market Efficiency

This paper documents that strategies which buy stocks that have performed well i n the past and sell stocks t ha t have performed poorly i n the past generate significant positive returns over 3to 12-month holding periods. W e find that the profitability o f these strategies are not due to their systematic risk or to delayed stock price reactions to common factors. However, part o f the abnormal returns generated i n the first year after portfolio formation dissipates i n the following two years. A similar pattern o f returns around the earnings announcements o f past winners and losers is also documented. A POPULAR VIEW HELD by many journalists, psychologists, and economists is that individuals tend to overreact to information.' A direct extension of this view, suggested by De Bondt and Thaler (1985, 19871, is that stock prices also overreact to information, suggesting that contrarian strategies (buying past losers and selling past winners) achieve abnormal returns. De Bondt and Thaler (1985) show that over 3to 5-year holding periods stocks that performed poorly over the previous 3 to 5 years achieve higher returns than stocks that performed well over the same period. However, the interpretation of the De Bondt and Thaler results are still being debated. Some have argued that the De Bondt and Thaler results can be explained by the systematic risk of their contrarian portfolios and the size effect."n addition, since the long-term losers outperform the long-term winners only in Januaries, it is unclear whether their results can be attributed to overreaction. *Jegadeesh is from the Anderson Graduate School o f Management, UCLA. Ti tman is from Hong Kong University o f Science and Technology and the Anderson Graduate School o f Management , UCLA. W e would like to thank Kent Daniel, Ravi Jagannathan, Richard Roll, Hans Stoll, Ren6 Stulz, and two referees. W e also thank participants o f ' theJohnson Symposium held at the University o f Wisconsin at Madison and seminar participants at Harvard, SMU, UBC, UCLA, Penn State, University o f Michigan, University o f Minnesota, and York University for helpful comments, and Juan Siu and Kwan Ho Kim for excellent research assistance. ' s e e for example, the academic papers by Kahneman and Tversky (1982), De Bondt and Thaler (1985)and Shiller (1981). ' s e e for example, Chan (19881, Ball and Kothari (1989),and Zarowin (1990). For a n alternate view, see the recent paper by Chopra, Lakonishok, and Ritter (1992). 66 The Journal of Finance More recent papers by Jegadeesh (1990) and Lehmann (1990) provide evidence of shorter-term return reversals. These papers show that contrarian strategies that select stocks based on their returns in the previous week or month generate significant abnormal returns. However, since these strategies are transaction intensive and are based on short-term price movements, their apparent success may reflect the presence of short-term price pressure or a lack of liquidity in the market rather than overreaction. Jegadeesh and Titman (1991) provide evidence on the relation between short-term return reversals and bid-ask spreads that supports this interpretation. In addition, Lo and MacKinlay (1990) argue that a large part of the abnormal returns documented by Jegadeesh and Lehmann is attributable to a delayed stock price reaction to common factors rather than to overreaction. Although contrarian strategies have received a lot of attention in the recent academic literature, the early literature on market efficiency focused on relative strength strategies that buy past winners and sell past losers. Most notably, Levy (1967) claims that a trading rule that buys stocks with current prices that are substantially higher than their average prices over the past 27 weeks realizes significant abnormal returns. Jensen and Bennington (1970), however, point out that Levy had come up with his trading rule after examining 68 different trading rules in his dissertation and because of this express skepticism about his conclusions. Jensen and Rennington analyze the profitability of Levy's trading rule over a long time period that was, for the most part, outside Levy's original sample period. They find that in their sample period Levy's trading rule does not outperform a buy and hold strategy and hence attribute Levy's result to a selection bias. Although the current academic debate has focused on contrarian rather than relative strength trading rules, a number of practitioners still use relative strength as one of their stock selection criteria. For example, a majority of the mutual funds examined by Grinblatt and Titman (1989, 1991) show a tendency to buy stocks that have increased in price over the previous quarter. In addition, the Value Line rankings are known to be based in large part on past relative strength. The success of many of the mutual funds in the Grinblatt and Titman sample and the predictive power of Value Line rankings (see Copeland and Mayers (1982) and Stickel (1985)) provide suggestive evidence that the relative strength strategies may generate abnormal returns. How can we reconcile the success of Value Line rankings and the mutual funds that use relative strength rules with the current academic literature that suggests that the opposite strategy generates abnormal returns? One possibility is that the abnormal returns realized by these practitioners are either spurious or are unrelated to their tendencies to buy past winners. A second possibility is that the discrepancy is due to the difference between the time horizons used in the trading rules examined in the recent academic papers and those used in practice. For instance, the above cited evidence favoring contrarian strategies focuses on trading strategies based on either Returns to Buying Winners and Selling Losers 67 very short-term return reversals (1 week or 1 month), or very long-term return reversals (3 to 5 years). However, anecdotal evidence suggests that practitioners who use relative strength rules base their selections on price movements over the past 3 to 12 month^.^ This paper provides an analysis of relative strength trading strategies over 3to 12-month horizons. Our analysis of NYSE and AMEX stocks documents significant profits in the 1965 to 1989 sample period for each of the relative strength strategies examined. We provide a decomposition of these profits into different sources and develop tests that allow us to evaluate their relative importance. The results of these tests indicate that the profits are not due to the systematic risk of the trading strategies. In addition, the evidence indicates that the profits cannot be attributed to a lead-lag effect resulting from delayed stock price reactions to information about a common factor similar to that proposed by Lo and MacKmlay (1990). The evidence is, however, consistent with delayed price reactions to firm-specific information. Further tests suggest that part of the predictable price changes that occur during these 3to 12-month holding periods may not be permanent. The stocks included in the relative strength portfolios experience negative abnormal returns starting around 12 months after the formation date and continuing up to the thirty-first month. For example, the portfolio formed on the basis of returns realized in the past 6 months generates an average cumulative return of 9.5% over the next 12 months but loses more than half of this return in the following 24 months. Our analysis of stock returns around earnings announcement dates suggests a similar bias in market expectations. We find that past winners realize consistently higher returns around their earnings announcements in the 7 months following the portfolio formation date than do past losers. However, in each of the following 13 months past losers realize higher returns than past winners around earnings announcements. The rest of this paper is organized as follows: Section I describes the trading strategies that we examine and Section I1 documents their excess returns. Section I11 provides a decomposition of the profits from relative strength strategies and evaluates the relative importance of the different components. Section IV documents these returns in subsamples stratified on the basis of ex ante beta and firm size and Section V measures these profits across calendar months and over 5-year subperiods. The longer term performance of the stocks included in the relative strength portfolios is examined in Section VI and Section VII back tests the strategy over the 1927 to 1964 3 ~ o r instance, one of the inputs used by Value Line to assign a timeliness rank for each stock is a price momentum factor computed based on the stock's past 3to 12-month returns. Value Line reports that the price momentum factor is computed by "dividing the stock's latest 10-week average relative price by its 52-week average relative price." These timeliness ranks, according to Value Line, are "designed to discriminate among stocks on the basis of relative price performance over the next 6 to 12 months" (see Bernard (19841, pp. 52-53). The Journal of Finance period. Section VIII examines the returns of past winners and past losers around earnings announcement dates and Section IX concludes the paper. I. Trading Strategies If stock prices either overreact or underreact to information, then profitable trading strategies that select stocks based on their past returns will exist. This study investigates the efficiency of the stock market by examining the profitability of a number of these strategies. The strategies we consider select stocks based on their returns over the past 1, 2, 3, or 4 quarters. We also consider holding periods that vary from 1to 4 quarters. This gives a total of 16 strategies. In addition, we examine a second set of 16 strategies that skip a week between the portfolio formation period and the holding period. By skipping a week, we avoid some of the bid-ask spread, pri