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Classic Research: Embrace Risk, But Take Profits

Posted in Momentum Investing, Volatility Effects

We have selected for retrospective review a few all-time “best selling” research papers of the past few years from the General Financial Markets category of the Social Science Research Network (SSRN). Here we summarize the February 1999 paper entitled “Daily Momentum And Contrarian Behavior Of Index Fund Investors” (download count almost 1,900) by William Goetzmann and Massimo Massa. The authors investigate the existence and profitability of momentum and contrarian behaviors for stock index trading. They classify return momentum investors (trend followers) as those who buy (sell) when the market rises (drops) in the previous trading session, and return contrarian investors as “profit takers” who sell (buy) when the market rises (drops). They also examine investor response to changes in market volatility, defining both volatility momentum traders (risk chasers) and volatility contrarian traders (risk avoiders). Using daily activity records for 91,000 accounts trading an S&P 500 index during 1997 and 1998, the authors find that:

  • Passive index fund holders trade infrequently, typically once a year, although some accounts are quite active. There are no calendar effects (end-of-year, end-of-month…) evident in the trading activity.
  • About 25% all accounts are return contrarians, and 12% are return momentum traders. Among frequent traders, however, more than 50% are return momentum players. There is a little bit more risk (volatility) chasing than risk avoiding.
  • Return contrarians (profit takers) tend to earn significantly higher profits than the rest of the market.
  • Risk chasers (volatility momentum traders) tend to earn higher profits than risk avoiders.

The authors also explore the impacts of momentum and contrarian investor behaviors on price, with focus on times when these behaviors are most dramatically opposed.

In summary, traders can outperform by entering positions when volatility spikes and then taking profits quickly.

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