Finance theory assumes investors buy stocks after considering their return potential, which makes sense. In reality they do anything but. In fact, one of the most common reasons for stock purchase, especially among retail investors, is a look back at where a stock’s price has come from.
Using a unique database, the EastMoney GUBA forum (here GUBA) the largest and most active online stock forum in China, researchers Siyuan Yang and Siyang Li from Tsinghua University set out to see if a profitable trading strategy could be extracted from this reliable trend-is-your-friend behavior?
What they discovered was a long-short strategy that (on back-testing) produced a 43% annual return and whose long-leg alone generated a 23% annual gain. What will be of especial interest to practitioners is where these effects were most pronounced.
Often these sort of academic long-short strategies work because they contain a large component of less liquid and difficult-in-reality to trade stocks.
Not so here where it was observed “.. stocks with higher turnover, less volatility, higher market value, lower valuation, lower earnings management, higher media or analyst coverage and higher disclosure gradings [Were] more exposed to extrapolation on their past returns” i.e. the big market leaders.
There is a downside to all this. The researchers noted also that where a high Degree of Extrapolation (DOX) was affecting a stock’s price the amount of real information in the price declined and that, in turn, produced a higher stock price crash risk.
To sum up then for the practically minded: if a stock price is going up it’ll most likely keep going up, until it doesn’t. Then it could go down a lot.
Always nice to have academia confirm a lifetime of experience! I’m being flippant. The paper deserves a full read and you can access it here Extrapolation and Future Returns.
Happy Sunday.