Market Efficiency in an Irrational World

Traditionally, economic theory takes the view that investors are rational; but several behavioral biases such as Overconfidence have been studied recently.  In particular, this overconfidence has been found to indirectly cause investors to underweight or overweight new information (caused by the "cognitive dissonance", "attribution bias", and "conservatism bias"), contributing to the momentum effect.  The authors propose that growth stocks (i.e., low book-to-market ratios) should exhibit higher momentum due to their value being less predictable (e.g., most of their assets are intangible) than more stable stocks.

The authors study the July 1963 - December 1997 period in the United States equity markets and find that stocks with high Book-to-Market characteristics (i.e., value stocks) and high TTM returns (i.e., momentum stocks) significantly outperformed their growth and low momentum counterparts, as well as the market portfolio.  The value/momentum portfolio outperformed the market portfolio by almost 0.60% per month.

The authors introduce "adaptive efficiency", which relaxes the efficient market hypothesis by adding behavioral theory.  They suggest that the "irrational investors" may tilt their portfolios to anomalies, while the "rational investors" assume that anomalies are corrected by rational investors and will not try to exploit the anomalies; and this will cause the anomalies (such as momentum) to persist.  The authors prove this to be the case over the 1974 - 1997 period in the United States equity markets.

DANIEL, K., & TITMAN, S. (1999). Market Efficiency in an Irrational World. Financial Analysts Journal, 55.