Different momentum effects across countries: An explanation based on investors' behavior

• Published date: 01 December 2023
• Author: Guoxiao Xia,Changsheng Hu,Huosong Xia,Yangchun Chi
• Date: 01 December 2023
• DOI: http://doi.org/10.1111/jfir.12351

Received: 5 August 2021

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Accepted: 30 August 2023

DOI: 10.1111/jfir.12351

ORIGINAL ARTICLE

Different momentum effects across countries: An

explanation based on investors' behavior

Guoxiao Xia

1

|Changsheng Hu

1

|Huosong Xia

2

|

Yangchun Chi

3

1

Economics and Management School, Wuhan

University, Wuhan, Hubei, China

2

School ofManagement, Wuhan Textile

University, Wuhan, Hubei, China

3

Ningbo Zorro Quant Co. Ltd., Chaoyang,

Beijing, China

Correspondence

Guoxiao Xia, Economics and Management

School, Wuhan University, Wuhan,

Hubei, China.

Email: xiaguoxiao@whu.edu.cn

Funding information

National Natural Science Foundation of

China, Grant/Award Numbers: 71671134,

71871172, 72171184

Abstract

We establish a model in which speculators use feedback

trading characteristics to infer the behavior of irrational

investors and induce them to trade. We also discuss the

stability and time series of asset prices. Our results show

that: (1) speculators have speculation and arbitrage

demands and make “noise”to induce irrational investors

to trade, (2) the time series of asset prices show stable

momentum and a reversal effect when fundamental traders

dominate the market, and (3) momentums are unstable and

perform poorly under extreme circumstances. Our article

offers a unique approach to understanding the micro

mechanism of different momentum effects in various

markets and suggests a plausible theoretical framework to

illustrate such differences.

JEL CLASSIFICATION

G12, G14

1|INTRODUCTION

We argue that the power of fundamental traders determines whether stable momentum profits exist in various

markets. We develop this argument by creating a model of trade inducement and provide microeconomic

interpretations for the behavior of the investors involved. Specifically, our work considers information and

sentiment inferences, which are neglected by De Long et al. (1990b), and suggests a novel theoretical framework to

interpret the behavior of speculators who conduct trade inducement. Our model also illustrates that the stability of

asset prices declines as the proportion of irrational investors rises. Most important, our work explains momentum

J Financ Res. 2023;46:1141–1163. wileyonlinelibrary.com/journal/JFIR

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© 2023 The Southern Finance Association and the Southwestern Finance Association.

effect differences in various markets and makes a unique contribution to the large literature on momentum and

trade inducement.

The momentum of asset prices is one of the most stable anomalies in the market (Fama, 1998). However, its

magnitude and significance vary greatly in different countries and regions. More cogent support comes from Chui

et al. (2010) and Famaand French (2012). They find that themomentum effect is notable in maturemarkets but is not

obvious in emergingmarkets in most cases. Though the factormodels (Carhart, 1995; Fama & French,1993,2015)do

make some progress in interpreting the momentum effect,they still cannot explain the momentum effectdifferences

in various markets. Different from empirical research, we focus on the different patternsof investors' behavior and

offer an approachto understanding the micro mechanismof different momentum effects in various markets.Empirical

studies also demonstrate that liquidity risk accounts for a considerable fraction of momentum portfolio returns. For

example, Sadka(2006) decomposes firm‐level liquidityinto variable and fixed price effects and demonstrates that the

variable (informational) component of liquidity risk can explain 40% of the cross‐sectional variation in expected

momentum portfolio returns. Similarly, Pastor and Stambaugh (2003) argue that systematic liquidity risk is a priced

risk factor and accounts for half of the momentum portfolio profits. Sadka (2006) also emphasizes the need for an

equilibriumasset pricing model to include an information‐based liquidityrisk factor. Momentum profits are stillstrong

in US markets though their significances drop to some extent. We establish a parsimonious model to explain why

momentum effectsare different across countriesand regions. The proportion of fundamentaltraders is closely related

to the significance of the momentum effects but is not the only factor. Moreover, liquidity risk and its influence on

momentum portfolio returns vary significantly from market to market. To what extent liquidity risk dampens

momentum profits is hardto measure in a unified framework. Hence, liquidity traders are not includedin our model,

and we apply indices in our empirical tests to avoid liquidity risk.

Plenty of studies illustrate that decision‐making behaviors are often irrational and biased and follow definite

rules (e.g., Griffin & Tversky, 1992; Kahneman & Tversky, 1979). We call such investors “irrational investors”in this

article, and they perform the same as the noise traders in De Long et al. (1990a). Conversely, investors who trade

according to fundamental values are rational investors or sophisticated investors. We divide such investors into two

categories: fundamental traders and speculators.

Fundamental traders buy when irrational investors depress prices and sell when irrational investors push prices

up based on the fundamental value of the asset. Generally speaking, fundamental traders dominate mature markets,

whereas irrational investors dominate emerging markets because the market system is imperfect and investors in

emerging markets are relatively low educated as stated by Mendel and Shleifer (2012). It is crucial to study

fundamental traders when discussing the momentum effect in various markets because the active contrarian

investment strategies of fundamental traders cannot push prices toward fundamentals all the way. Most

researchers base their studies of market participants on mature markets and do not consider emerging markets. In

our work, we discuss the behavior patterns of speculators and differences in the time series of asset prices by

setting various proportions of fundamental traders in the market.

Because the market is not informationally efficient (Grossman & Stiglitz, 1980), investors cannot obtain

sufficient information. Therefore, it is vital to infer other investors’information before making decisions. Keynes

(1936) stresses the importance of such information inference among market participants. Our paper not only

considers information inference but also a mechanism called trade inducement. Investors who infer irrational

investors’trading patterns are called speculators. They avail their advantages in capital and information and induce

irrational investors to trade. Our main finding that speculators have speculation and arbitrage demands, and they

make “noise”to induce irrational investors to trade, reflects a view of speculation that is closely related to reality.

Such speculation is motivated in part by George Soros's (1987) description of his own investment strategy. Soros

was successful during the 1960s conglomerate and 1970s real estate investment trust (REIT) booms. The initial

price rise in conglomerate stocks, caused in part by purchases by speculators like Soros, attracted irrational

investors because it created a trend of increasing prices. As irrational investors bought more, stock prices rose

further due to such positive feedback trading. Although in the end disinvestment or short sales by smart money

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