LongTerm Return Reversals Overreaction or Taxes By Thomas

Long-Term Return Reversals: Overreaction or Taxes By Thomas J. George and Chuan-Yang Hwang Discussant: Chin-Wen Hsin Yuan Ze University

Outline of the study n Purpose of the study: Testing alternative hypotheses for explaining long-term reversals in stock returns: n Overreaction Hypothesis n n n Investors make systematic mistakes when they react to information. Predicts that both winners and losers reverse. Capital Gains Lock-in Hypothesis n n Investors with lock-in gains have an incentive not to sell winners in order to delay paying capital gains taxes. Klein (1999, 2000) Predicts that reversals are associated only with gains (winners).

Outline of the study n Five measures to identify W or L: n n TR: FYH: n n n Treats gains and losses symmetrically. EWGO: average embedded gains only n n n Test whether winners reverse If winner reversals are caused by overreaction, then the indicator FYH-winner should dominate TR in explaining winner reversals. EWGL: average embedded net gains n n historical returns nearness of the 5 -year high Specifically recognizes the asym. in reversals predicted by CGLI. If CGLI hypothesis is correct, EWGO should dominate EWGL. FYL: n nearness of the 5 -year low To compensate EWGO in that tax deferral benefits are a convex function of the embedded gain.

Outline of the study n Method: n n n Compare the explanatory power of predictors of long-term reversals that are based on different hypotheses. Similar to George and Hwang (JF, 2004) but with different measures. Major findings: n n è Measures based on the overreaction hypothesis have no predictive power; Measures based on the capital gains lock-in effect do have predictive power. Long-term reversals are not caused by investor overreaction. Instead, they reflect the investor behavior of locking in capital gains for tax purposes.

Outline of the study n Contributions of the study n n Reversals are asymmetric wrt gains vs. losses. Trying to disentangle the connection between the phenomenon of short-term momentum and that of long-term reversals (cp. BSV, DHS, HS)

Suggestions n Very interesting and well written paper. n Robustness check: n n n In addition to 5 -yrs in FYH: 3 -yr, 6 -yr, …? Try EWLO (Loss only)? Sub-period analysis Is the phenomenon size-specific? Results support asymmetries in long-term reversals but n n alternative explanations for the result? Other factors explaining the asymmetry?

Suggestions n Odean (1998) vs. CGLI hypothesis n n Disposition effect: Investors tend to hold losers too long and sell winners too soon. Investors' reluctance to realize losses is at odds with optimal tax-loss selling for taxable investments. For tax purposes investors should postpone taxable gains by continuing to hold their profitable investments - CGLI. Tax-motivated selling is most evident in December. Investors are reluctant to sell for a loss but recognize the tax benefits and thus sell their losers in December.

Suggestions n Reservations on the HK result: n n Lack of reversals (or even momentum) may be due to other institutional factors. Role of industry momentum here?