NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

When are Contrarian Profits Due to Stock Market Overreaction?

Andrew W. Lo, A. Craig MacKinlay

NBER Working Paper No. 2977 (Also Reprint No. r1502)
Issued in May 1989
NBER Program(s):   ME

The profitability of contrarian investment strategies need not be the result of stock market overreaction. Even if returns on individual securities are temporally independent, portfolio strategies that attempt to exploit return reversals may still earn positive expected profits. This is due to the effects of cross-autocovariances from which contrarian strategies inadvertently benefit. We provide an informal taxonomy of return-generating processes that yield positive [and negative] expected profits under a particular contrarian portfolio strategy, and use this taxonomy to reconcile the empirical findings of weak negative autocorrelation for returns on individual stocks with the strong positive autocorrelation of portfolio returns. We present empirical evidence against overreaction as the primary source of contrarian profits, and show the presence of important lead-lag relations across securities.

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Document Object Identifier (DOI): 10.3386/w2977

Published: The Review of Financial Studies, Vol. 3, No. 2, pp. 175-205, (1990). citation courtesy of

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