Sunday, September 7, 2014

What causes asset price momentum?

The answer to what causes asset price momentum is that there are a lot of reasons. However, no one has been able to decompose the impact of any one reason for momentum and given the reasons change through time, we can say that momentum will change across time and asset classes. We can also conclude there are broad set of reasons for why momentum may occur which helps to explain its persistence.

A good working list for why momentum occurs:
  • Behavioral biases. There is a long list of behavioral biases which may induce trend behavior. The list includes: framing, anchoring of expectations, and extrapolation of expectations. Overconfidence issues which creates a willingness to hold more of what has gone up. Investors both under and overreact to information which will lead to longer-term adjustment in prices. Investors may have a hard time actually processing the many sources of information on the market. If there is not super rationality by the majority of investors, there will be room for behavioral biases to affect prices.
  • Market frictions which stop prices from following their rational equilibrium. For example, information diffusion can lead to trends.
  • Risk premium stories where momentum is consistent with increasing or changing risk.
  • Positive feedback or overreaction to markets; noise traders. The noise trades follow trends and past behavior and may outweigh the rational investors. This was a popular view in the late 80's. This can viewed as another way of invoking behavioral biases.
  • Herding. This could be a viewed as the next generation of positive feedback models. If everyone is thinking the same or change their views at the same time there will be herding. 
  • The disposition effect. Investors hang onto their losers which places a wedge between market and fundamental prices. Prices will under-react to information which leads to trends. Markets that have had large capital gains will show persistence in returns.
  • Risk factors and growth - the fundamentals. If fundamental trend there will be a trend in asset prices. For example, the same direction of monetary policy will lead to asset prices consistent with that policy. Easing will force short-term rates down. 
  • Fund flows. This is driven by many of the above reasons but flows will lead to price changes as demand changes cause a need for equilibrium price adjustments. This could be a liquidation effect when there is deleveraging.

Clearly, there are a wide set of  reasons for trends to occur in all asset classes.

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