Cognitive Dissonance, Sentiment, and Momentum

TLDR

The study examines how sentiment influences momentum strategy profitability, noting that under optimism losers become underpriced while under pessimism winners do so. The authors hypothesize that news conflicting with investor sentiment induces cognitive dissonance, slowing its diffusion. Short‑selling constraints may hinder arbitrage of losers, thereby reinforcing momentum when markets are optimistic. Empirically, momentum profits materialize only under optimism, with small investors delaying the sale of losers and momentum‑based hedge portfolios formed in optimistic periods experiencing long‑run reversals.

Abstract

Abstract We consider whether sentiment affects the profitability of momentum strategies. We hypothesize that news that contradicts investors’ sentiment causes cognitive dissonance, slowing the diffusion of such news. Thus, losers (winners) become underpriced under optimism (pessimism). Short-selling constraints may impede arbitraging of losers and thus strengthen momentum during optimistic periods. Supporting this notion, we empirically show that momentum profits arise only under optimism. An analysis of net order flows from small and large trades indicates that small investors are slow to sell losers during optimistic periods. Momentum-based hedge portfolios formed during optimistic periods experience long-run reversals.