Do Winners Perform Better Than Losers? A Stochastic Dominance Approach

Abstract

AbstractThis paper offers an alternative view supporting the risk-based explanation of the momentum effect. Using stochastic dominance criteria, we find that the winners portfolio and the losers portfolio do not dominate each other. In general, the winners portfolio dominates at the right-hand side of the distribution of returns while the losers portfolio dominates at the left-hand side of the distribution. Our empirical results imply that the momentum profits provide neither an arbitrage opportunity nor a welfare improvement for rational investors ex ante. We interpret the evidence as follows: momentum profits are consistent with the notion of market rationality and market efficiency and are likely to be explained by omitted risk factors. Our findings also suggest that one possible reason why some investors prefer losers is because of less downside risk.

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