Chapter 14
A UNIFIED THEORY OF UNDERREACTION,
MOMENTUM TRADING, AND OVERREACTION
IN ASSET MARKETS
Harrison Hong and Jeremy C. Stein
Over the lastseveral years, a large volume of empirical work has docu-
mented a variety of ways in which asset returns can be predicted based on
publicly available information. Although different studies have used a host
of different predictive variables, many of the results can be thought of as
belonging to one of two broad categories of phenomena. On the one hand,
returns appear to exhibit continuation, or momentum, in the short to
medium run. On the other hand, there is also a tendency toward reversals,
or fundamental reversion, in the long run.
It is becoming increasingly clear that traditional asset-pricing models—
such as the capital asset pricing model (CAPM) of Sharpe (1964) and Lint-
ner (1965), Ross’s (1976) arbitrage pricing theory (APT) or Merton’s (1973)
intertemporal capital asset pricing model (ICAPM)—have a hard time ex-
plaining the growing set of stylized facts. In the context of these models, all
of the predictable patterns in asset returns, at both short and long horizons,
must ultimately be traced to differences in loadings on economically mean-
ingful risk factors. And there is little affirmative evidence at this point to
suggest that this can be done.
As an alternative to these traditional models, many are turning to “be-
havioral” theories, where “behavioral” can be broadly construed as involv-
ing some departure from the classical assumptions of strict rationality and
unlimited computational capacity on the part of investors. But the difficulty
with this approach is that there are a potentially huge number of such de-
partures that one might entertain, so it is hard to know where to start.
This research is supported by the National Science Foundation and the Finance Research Cen-
ter at MIT. We are grateful to Denis Gromb, René Stulz, an anonymous referee, and seminar
participants at MIT, Michigan, Wharton, Duke, UCLA, Berkeley, Stanford, and Illinois for
helpful comments and suggestions. Thanks also to Melissa Cunniffe for help in preparing the
manuscript. This is a slightly revised version of a paper of the same title that appeared in the
Journal of Financein December 1999. It also incorporates some material from our joint paper
with Terence Lim “Bad news Travels Slowly: Size, Analyst Coverage, and the Profitability of
Momentum Strategies.”