Skewness Preference, Range-based Expectations, and Stock Market Momentum

Abstract

Momentum is a pervasive characteristic of financial markets that lacks a broadly accepted explanation. In addition to its longstanding challenge to asset pricing theory, recent work finds that momentum poses a challenge for expected utility (EU) theory, opening an avenue for new decision theoretic explanations. In this paper, we provide a new decision theoretic and equilibrium foundation for momentum in stock returns. We consider a representative agent who exhibits a disciplined deviation from EU (exhibiting a preference for positively skewed returns), and who exhibits a disciplined deviation from rational expectations (exhibiting range-based expectations in which an asset is expected to trade next period within its price range over the past year). In a general equilibrium setting that generalizes the classical consumption capital asset pricing model, our representative agent economy exhibits momentum in stock returns. Momentum arises from a new mechanism in which the representative agent truncates the tails of the distribution at an asset's historical trading range. Consequently, a current price near the bottom (top) of the trading range is perceived by the agent as more positively (negatively) skewed, which by skewness preference has lower (higher) subsequent average returns. We conduct a simulation where the agent's preference parameters are calibrated to prior experimental estimates and show quantitatively that the model generates a sizeable momentum premium as in the data. We further provide an aggregation result in which the same asset prices arise in equilibrium from an economy with some behavioral agents (exhibiting skewness preference) and some traditional EU agents.

Keywords: skewness preference, momentum, ranged-based expectation, efficient market hypothesis

JEL Classification: D81, G12, G14, G40