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Market Efficiency in an Irrational World
Kent Daniel and Sheridan Titman
Financial Analysts Journal
Vol. 55, No. 6, Behavioral Finance (Nov. - Dec., 1999), pp. 28-40
Published by: CFA Institute
Stable URL: http://www.jstor.org/stable/4480207
Page Count: 13
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We discuss why investors are likely to be overconfident and how this behavioral bias affects investment decisions. Our analysis suggests that investor overconfidence can generate momentum in stock returns and that this momentum effect is likely to be strongest in those stocks whose valuations require the interpretation of ambiguous information. Consistent with this analysis, we found that momentum effects are stronger for growth stocks than for stable stocks. A portfolio strategy based on this hypothesis generated strong abnormal returns from U.S. equity portfolios that did not appear to be attributable to risk. Although these results violate the traditional efficient market hypothesis, they do not necessarily imply that rational but uninformed investors could have actually achieved the returns without the benefit of hindsight. To examine whether unexploited profit opportunities exist, we tested for a somewhat weak form of market efficiency, adaptive efficiency, that allows for the appearance of profit opportunities in historical data but requires these profit opportunities to dissipate when they become apparent. Our tests rejected the notion that the U.S. equity market is adaptive efficient.
Financial Analysts Journal © 1999 CFA Institute