momentum returns in the holding period will be followed by negative re-
turns since the delayed overreaction must be subsequently reversed. Hence,
these behavioral models suggest that we should examine the long-term
profitability of momentum strategies to understand whether momentum is
driven by underreaction or by delayed overreaction.
Delong, Shleifer, Summers, and Waldman (1990) were among the first to
formally model how irrational portfolio strategies could affect asset prices.
In particular, they argue that investors tend to follow “positive feedback
trading strategies” (investment strategies that buy past winners and sell
past losers). They show that such investor behavior will cause market
prices to deviate from fundamental values in the short run and give rise to a
momentum effect. As prices revert to fundamentals, long-horizon returns
exhibit reversals. To a large extent, the subsequent literature presents be-
havioral models that formalize how various behavioral biases can lead in-
vestors to follow positive feedback strategies.
Barberis, Shleifer, and Vishny (1998) discuss how a “conservatism bias”
might lead investors to underreact to information, giving rise to momentum
profits. The conservatism bias, identified in experiments by Edwards
(1968), suggests that investors tend to underweight new information when
they update their priors. If investors act in this way, prices are slow to in-
corporate new information, but once prices fully incorporate information,
there is no further predictability in stock returns.
Additionally, Barberis et al. assume that investors also suffer from a
“representative heuristic” bias, which gives rise to delayed overreaction.
The representative heuristic bias, as Tversky and Kahneman (1974) origi-
nally describe, is the tendency of individuals to identify “an uncertain
event, or a sample, by the degree to which it is similar to the parent popula-
tion.” In the context of stock prices, Barberis et al. argue that this bias leads
investors to mistakenly conclude that firms that exhibit consistently ex-
traordinary earnings growths will continue to experience similar extraordi-
nary growth in the future. They argue that although the conservatism bias
in isolation leads to underreaction, this bias in conjunction with the repre-
sentative heuristic can lead to prices overshooting their fundamental values
in the short run and return reversals in the long run.^6
Daniel, Hirshleifer, and Subramanyam (1998), and Hong and Stein
(1999) propose alternative models that are also consistent with short-term
momentum and long-term reversals. Daniel et al. argue that the behavior of
informed traders can be characterized by a “self-attribution” bias. In their
model, investors observe positive signals about a set of stocks, some of
MOMENTUM 371(^6) The time horizon over which various biases come into play in the Barberis et al. (and in
other behavioral models) is unspecified. One could argue that the six-month ranking period
used in this paper may not be long enough for delayed overreaction due to the representative
heuristic effect. In such an event we would only observe underreaction due to the conservatism
bias.