Thanks to Abnormal Returns for steering us to this paper on psychology and price momentum. Makes for excellent weekend reading:
This paper sheds empirical light on whether investor sentiment affects the profitability of price momentum strategies. We hypothesize that when investors are optimistic, their expectations will be more miscalibrated relative to those obtained from objective
probabilities, and arbitrage will be more difficult with short-selling constraints. Our results show that momentum rises only when investors are optimistic, and that optimistic momentum portfolios experience long-run reversals. These results provide support to the behavioral theories, suggesting that short-run momentum and long-run reversal commonly arise from investors’ behavioral biases.