An Anatomy of Trading

Strategies
Jennifer Conrad
University of North Carolina

Gautam Kaul
University of Michigan

In this article we use a single unifying framework to an-

alyze the sources of profits to a wide spectrum of return-
based trading strategies implemented in the literature.
We show that less than 50% of the 120 strategies imple-
mented in the article yield statistically significant profits
and, unconditionally, momentum and contrarian strate-
gies are equally likely to be successful. However, when we
condition on the return horizon (short, medium, or long)
of the strategy, or the time period during which it is im-
plemented, two patterns emerge. A momentum strategy
is usually profitable at the medium (3- to 12-month) hori-
zon, while a contrarian strategy nets statistically signifi-
cant profits at long horizons, but only during the 1926–
1947 subperiod. More importantly, our results show that
the cross-sectional variation in the mean returns of in-
dividual securities included in these strategies plays an
important role in their profitability. The cross-sectional
variation can potentially account for the profitability of
momentum strategies and it is also responsible for atten-

We thank Jonathan Berk, Elazar Berkovitch, Kobi Boudoukh, Gene Fama,

Michael Ferguson, Julian Franks, Thomas George, Richard Green, Mustafa
Gültekin, Narasimhan Jegadeesh, Charles Jones, Roni Michaely, Steve Manaster,
Vasant Naik, Sheridan Titman, Jamie Zender, and seminar participants at Ari-
zona State University, Cornell University, Michigan State University, University
of Arizona, University of British Columbia, University of North Carolina, Uni-
versity of Notre Dame, University of Utah, the Winter Finance Conference at the
University of Utah, the American Finance Association Meetings, San Francisco,
and the Summer Finance Seminar at Tel Aviv University for helpful comments
and suggestions. We are especially thankful to an anonymous referee and Bob Ko-
rajczyk and Ravi Jagannathan for helping us focus on the main issues addressed
in this article, to Michael Cooper for his invaluable research assistance, and to
Sonja Dodenbier for helping prepare this manuscript. Partial funding for this
project is provided by the Kenan-Flagler Business School, University of North
Carolina and the University of Michigan Business School. Address correspon-
dence to Gautam Kaul, Department of Finance, University of Michigan Business
School, Ann Arbor, MI 48109-1234.

The Review of Financial Studies Fall 1998 Vol. 11, No. 3, pp. 489–519
°c 1998 The Society for Financial Studies
 The Review of Financial Studies / v 11 n 3 1998

uating the profits from price reversals to long-horizon contrarian strate-

gies.

Trading strategies that apparently “beat the market” date back to the incep-
tion of trading in financial assets. A number of practitioners and academics
in the pre-market-efficiency era (i.e., pre-1960s) believed that predictable
patterns in stock returns could lead to “abnormal” profits to trading strate-
gies. In fact, Keynes (1936) succinctly summarized the views of many by
stating that most investors’ decisions “can be taken only as a result of animal
spirits. . . .” In recent years there has been a dramatic resurgence of academic
interest in the predictability of asset returns based on their past history. More
significantly, a growing number of researchers argue that time-series pat-
terns in returns are due to market inefficiencies and can, consequently, be
consistently translated into “abnormal” profits.1
Broadly speaking, these articles analyze two strategies, diametrically
opposed in philosophy and execution: the contrarian strategy that relies on
price reversals and the momentum strategy based on price continuations
(or “momentum” in asset prices). Until recently there has been relatively
more emphasis on contrarian strategies, but there is growing evidence that
price continuations result in consistent “abnormal” profits to momentum
strategies. One of the most perplexing aspects of this literature is that these
two diametrically opposed strategies appear to “work” simultaneously, al-
beit for different investment horizons. Specifically, contrarian strategies are
apparently profitable for the short-term (weekly, monthly) and long-term
(3- to 5-year, or longer) intervals, while the momentum strategy is profitable
for medium-term (3- to 12-month) holding periods.
In this article we attempt to determine the sources of the expected prof-
its of the entire class of trading strategies that are based on information
contained in past returns of individual securities. The strength of our anal-
ysis is that we use a single framework, which builds on the analyses in
Lehmann (1990) and Lo and MacKinlay (1990), to decompose the profits
of all strategies, contrarian or momentum and short term to long term. This
decomposition is important because profits to trading strategies based on

1
For earlier analyses of patterns in security returns, and/or trading strategies based on these patterns, see,
among others, Alexander (1961, 1964), Cootner (1964), Fama (1965, 1970), Fama and Blume (1966),
Levy (1967), Van Horne and Parker (1967), James (1968), and Jensen and Bennington (1970).
A few of the numerous recent articles that deal with return predictability are Conrad and Kaul (1988,
1989), Fama and French (1988), Lo and MacKinlay (1988), Porterba and Summers (1988), Campbell,
Grossman, and Wang (1993), Richardson (1993), Boudoukh, Richardson, and Whitelaw (1994), Conrad,
Hameed, and Niden (1994), and Jones (1994). And notable among recent articles that document the
apparent profitability of trading strategies based on such predictability are DeBondt and Thaler (1985),
Chan (1988), Sweeney (1988), Jegadeesh (1990), Lehmann (1990), Lo and MacKinlay (1990), Levich
and Thomas (1991), Brock, Lakonishok, and LeBaron (1992), Chopra, Lakonishok and Ritter (1992),
Allen and Karjalainen (1993), Jegadeesh and Titman (1993, 1995a), and Asness (1994). Kaul (1997)
provides a review of the empirical methodologies used to uncover return predictability.

490
An Anatomy of Trading Strategies

securities’ past performance contain two components: one that results from
time-series predictability in security returns and another that arises due to
cross-sectional variation in the mean returns of the securities comprising
the portfolio.
Most return-based trading strategies implemented in the literature rely
exclusively on the existence of time-series patterns in returns. Specifically,
all such strategies are based on the premise that stock prices do not follow
random walks. However, the actual profits to the trading strategies imple-
mented based on past performance contain a cross-sectional component that
would arise even if stock prices are completely unpredictable and do follow
random walks. Consider, for example, a momentum strategy. The repeated
purchase of winners from the proceeds of the sale of losers will, on aver-
age, be tantamount to the purchase of high-mean securities from the sale of
low-mean securities. Consequently, as long as there is some cross-sectional
dispersion in the mean returns of the universe of securities, a momentum
strategy will be profitable. Conversely, a contrarian strategy will be un-
profitable on average even in a world where stock prices follow random
walks. It is important to determine the sources of the apparent profitability
of trading strategies because of (i) the explicit assumption in the literature
that time-series patterns in stock prices form the sole basis of return-based
trading strategies, and (ii) that the lack of predictability in stock returns is
viewed by some as synonymous with market efficiency [see Fama (1970,
1991)].
We implement and analyze a wide spectrum of trading strategies dur-
ing the 1926–1989 period, and during subperiods within, using the en-
tire sample of available NYSE/AMEX securities. Specifically we analyze
eight basic strategies with holding periods ranging between 1 week and
36 months. We find that 55 out of 120 trading strategies implemented using
all NYSE/AMEX securities yield statistically significant profits. The un-
conditional probabilities of success of momentum and contrarian strategies
are approximately equal: of the 55 statistically profitable strategies, 30 are
momentum, while 25 are contrarian strategies. More importantly, when we
ex post condition on the return horizon of the strategy and/or the subperiod
during which it is implemented, two patterns emerge that are consistent
with the literature on returns-based trading strategies [see, e.g., DeBondt
and Thaler (1985) and Jegadeesh and Titman (1993)]. The momentum strat-
egy usually nets positive, and frequently statistically significant, profits at
medium horizons, except during the 1926–1947 subperiod, while a con-
trarian strategy is successful at long horizons, although the profits to these
strategies are statistically significant only during the 1926–1947 subperiod.
An empirical decomposition of the profits of the strategies suggests
that the cross-sectional variation in mean returns of individual securities
included in the strategy is an important determinant of their profitabil-
ity. Specifically, we cannot reject the hypothesis that the in-sample cross-

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sectional variation in mean returns can explain the profitability of momen-

tum strategies. The cross-sectional dispersion in mean returns appears to
also be responsible for the paucity of statistically profitable contrarian strate-
gies. Although we consistently observe statistically significant price rever-
sals at virtually all horizons, the profits emanating from these reversals are
typically neutralized by the losses due to the large cross-sectional variance in
mean returns. Consequently, statistically significant net profits to contrarian
strategies are observed only in the “unusual” 1926–1947 subperiod.
It is important to note that our decomposition of trading profits is based
on the assumption of mean stationarity of the returns of individual securities
during the period in which the strategies are implemented. Also, the mean
returns are estimated for a wide cross-section of firms with a finite set
of time-series observations, which will result in an exaggeration of the
importance of the cross-sectional variation in mean returns. To gauge the
robustness of our empirical decomposition of the profits of trading strategies,
we conduct bootstrap and Monte Carlo simulations of the medium-term (3-
to 12-month) strategies in which we attempt to eliminate the time series
properties of security returns, while maintaining their unconditional cross-
sectional characteristics. The results from the simulations are consistent
with the hypothesis that the profits of momentum strategies are largely due to
cross-sectional variation in mean returns. Our Monte Carlo experiments also
suggest that our results are robust to the exclusion of “extreme” in-sample
mean returns. Finally, we present some alternative estimates of the relative
importance of the cross-sectional variation in mean returns in generating the
profits of trading strategies. Even the most conservative estimates suggest
that the cross-sectional variation in mean returns is a nontrivial determinant
of the profitability of trading strategies.
Clearly, different specifications for the expected returns of individual
securities could alter our conclusions. In addition, traders may view the
cross-sectional variation in mean returns as a source of “abnormal” profits.
We do not attempt to analyze the sources, rational or irrational, of the cross-
sectional variation in mean returns, that is, we do not attempt to explain
cross-sectional differences in mean returns using an asset-pricing model.
Our goal is to determine the relative importance of cross-sectional versus
time-series properties of asset returns in determining the profitability of
trading strategies. We believe our analysis and results should be of interest
to both technical traders and “producers” of asset-pricing models.
Section 1 contains a description of the trading strategies implemented in
this article and their profitability when applied to NYSE/AMEX securities
during various time periods. In Sections 2 and 3 we present a detailed
analysis of the decomposition of the profits of the strategies. Section 4
contains a brief summary and our conclusions.

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 An Anatomy of Trading Strategies

1. The Profitability of Trading Strategies

We consider a set of trading strategies that either explicitly mimic or capture
the essence of previously implemented strategies. Specifically, consider
buying or selling stocks at time t − 1 based on their performance from time
t − 2 to t − 1, where the period {t − 1, t} spans any finite time interval.
Also, assume that the “performance” of a stock is determined relative to
the average performance of all stocks that are used in the trading strategy.
Consequently, if the entire universe of assets is included in the strategy, then
each stock’s performance is measured relative to the return on the equal-
weighted “market portfolio,” Rmt . Finally, let wit−1 denote the fraction of
the trading strategy portfolio devoted to security i [see Lehmann (1990) and
Lo and MacKinlay (1990)], that is,
1
wit−1 (k) = ± [Rit−1 (k) − Rmt−1 (k)] (1)
N
where Rit−1 (k) is the return on security i at time t − 1, i = 1, . . . , N ,
Rmt−1 (k) is the return on equal-weighted portfolio of all securities, and k
is the length of the time-interval {t − 1, t}.
Since the weights are based entirely on information at time t − 1, wit−1
has a subscript of t − 1. The expression for the weights in Equation (1) suc-
cinctly captures the philosophy of all return-based trading strategies. First,
the positive or negative sign preceding the expression on the right-hand side
reflects an investor’s (institution’s) beliefs; that is, whether the investor be-
lieves in price continuations or reversals (and therefore recommends and/or
follows a momentum or a contrarian strategy). Second, it is important to
note that, regardless of whether a strategy is contrarian or momentum, the
premise is that its success is based on the time-series behavior of asset
prices. Specifically, a security’s past performance relative to some bench-
mark (e.g., the average return of the portfolio of all securities) is supposed
to be informative about future innovations in the security’s prices. This
is quite contrary, for example, to the random walk model of stock prices
which implies that changes in stock prices are completely unpredictable
(see Section 2 for further details). Third, the dollar weights in Equation (1)
[i.e., w1t−1 (k), . . . , w N t−1 (k)] lead to an arbitrage (zero cost) portfolio by
construction
X N
wit−1 (k) = 0 ∀ k, (2a)
i=1

and the dollar investment long (or short) is given by

1X N
It−1 (k) = |wit−1 (k)|. (2b)
2 i=1

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Fourth, since the weights in Equation (1) are proportional to the ab-
solute value of the deviations of a security’s return from the return of an
equal-weighted portfolio of all securities, they capture the general belief
that extreme price movements are followed by extreme movements [see,
e.g., DeBondt and Thaler (1985), Lehmann (1990), Lo and MacKinlay
(1990), and Jegadeesh and Titman (1993)]. Finally, and most importantly,
the weights in Equation (1) allow us to conveniently decompose the prof-
its of the trading strategies [see Lehmann (1990) and Lo and MacKinlay
(1990)], again regardless of the inherent nature of the strategy (i.e., whether
it is a contrarian or a momentum strategy). This, in turn, permits us to
determine the relative importance of the different components.2
The realized profits at time t, πt (k), to the trading strategies implied by
the weights in Equation (1) are given by

X
N
πt (k) = wit−1 (k)Rit (k). (3)
i=1

Since all the strategies considered in this article (and typically in the
literature) are zero-cost strategies, only the dollar profits (and not the returns)
are defined as in Equation (3). And if the markets are frictionless, the weights
can be arbitrarily scaled to obtain any level of profits. We therefore will
largely rely on the sign and statistical significance of the averages of the
time series of the πt (k)’s; that is, we examine whether expected profits are
statistically significantly positive (or negative).
Table 1 contains average/expected profits for trading strategies imple-
mented during different time periods and for different holding periods (i.e.,
different k). We consider five time periods: 1962–1989; 1926–1989, and
three equal-size subperiods within the 1926–1989 period (January 1926–
April 1947, May 1947–August 1968, September 1968–December 1989).
We first implement the strategies for the 1962–1989 period because it cor-
responds with the time period used in several past studies [see, e.g., Lehmann
(1990), Lo and MacKinlay (1990), and Jegadeesh and Titman (1993)]. The
1926-1989 period is used (for all but the weekly holding period) because
it covers a much longer time interval, and this interval (and the subperiods
within it) provide a robustness check for the potential profitability of trading
strategies.
We use eight different holding periods k, where k ranges from 1 week

2
Jegadeesh and Titman (1993) use a variant of this strategy in which securities are ranked based on their
past performance and are then combined into 10 portfolios that are held for a specific period of time. An
arbitrage portfolio is also formed by buying the top performers and selling the worst performers. They
note that the correlation between the returns to the strategy used in this article and their work is 0.95;
however, the profits of their strategy cannot be readily decomposed. We follow the weighting scheme
implied in Equation (1) instead, especially since a decomposition of the profits is central to this article.
The weights in Equation (1), however, do retain the same philosophy as the other return-based strategy.

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Table 1
Average profits to trading strategies for different horizons and periods

Strategy Subperiods (1926–1989)

interval 1962–1989 1926–1989 (I) 1926–1946 (II) 1947–1967 (III) 1968–1989
1 week −0.035 — — — —
(−23.30)
3 months 0.027 −0.165 −0.557 0.070 −0.020
(0.67) (−2.42) (−2.99) (2.91) (−0.43)
6 months 0.360 0.147 −0.204 0.333 0.273
(4.55) (1.91) (−1.03) (4.97) (3.63)
9 months 0.708 0.488 0.276 0.487 0.634
(5.81) (5.48) (1.37) (5.09) (5.44)
12 months 0.701 0.198 −0.557 0.372 0.611
(4.64) (1.29) (-1.44) (3.80) (3.70)
18 months 0.094 −0.761 −2.466 −0.117 0.444
(0.35) (−2.88) (−3.49) (−0.77) (1.51)
24 months −0.501 −1.181 −2.831 −0.434 0.792
(−0.97) (−2.98) (−2.92) (−1.62) (1.54)
36 months −3.304 −4.176 −7.727 −0.922 −0.873
(−3.39) (−6.48) (−6.08) (−1.24) (−0.84)
This table contains average profits to zero-cost trading strategies that buy NYSE/AMEX
winners and sell losers based on their past performance relative to the performance of an
equal-weighted index of all stocks. The dollar profits are given by πt (k) = 6i=1
N w
it−1 (k)Rit (k)
i = 1, . . . , N , where πt (k) is the dollar profit at time t from a k-period trading strategy,
wit−1 (k) = N1 [Rit−1 (k) − Rmt−1 (k)] and Rmt−1 (k) = N1 6i=1 N R
it−1 (k), where k = 1 week,
and 3, 6, 9, 12, 18, 24, and 36 months. The numbers in parentheses are z-statistics that are
asymptotically N (0, 1) under the null hypothesis that “true” profits are zero and are robust to
heteroscedasticity and autocorrelation, and account for any cross-correlation in the realized
profits of strategies within a horizon class (short, medium, or long horizon) of strategies. All
profit estimates are multiplied by 100.

to 36 months. For brevity we implement strategies for which the length of

the past performance evaluation periods and the future holding periods are
identical. For example, if we evaluate a security’s performance over the past
3-month period, the holding period of the trading strategy is also 3 months.
Due to data availability considerations, we implement the weekly trading
strategy only during the 1962–1989 period.
To minimize small-sample biases in estimators of the components of the
profits of trading strategies (see Appendix), and to increase the power of our
tests, we implement trading strategies for overlapping holding periods on a
monthly frequency (for all k except k = 1 week). Specifically, we determine
the weights, wit−1 (k) , at time t − 1 for all the different k’s based on the
returns from time t − 2 to t − 1. The different holding period strategies can
therefore contain different sets of securities. We then calculate the realized
profits at time t using Equation (3) for each k. To avoid potential “survival”
biases [see, e.g., Brown, Goetzmann, and Ross (1995)], we do not require
that all securities included in a particular strategy at time t − 1 also have
prices available at time t. If a security is included in a k-period strategy based
on its past k-period performance, but it survives for less than k periods in the

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future (because it is delisted), we use a (k − j) period return in calculating

πt (k), where j is the period of delisting. The estimates in Table 1 are the
time-series averages, for each k, of the profits at each time t, πt (k).
Finally, since the profits of momentum (contrarian) strategies are exactly
equal to the losses of contrarian (momentum) strategies [see Equations (1)
and (3)], we implement only momentum strategies (i.e., we use the weights
wit−1 = + N1 [Rit−1 (k) − Rmt−1 (k)] ∀ k). Consequently, a positive (nega-
tive) estimate in Table 1 implies that on average a momentum (contrarian)
strategy is profitable.
Table 1 also contains the z-statistics in parentheses to test the statistical
significance of the average profits (losses); these statistics are asymptoti-
cally N (0, 1) under the null hypothesis that the “true” profits are zero. We
use a generalized method of moments [see Hansen (1982)] procedure to
calculate standard errors. This procedure takes into account cross-sectional
correlations (within a particular time period) in the realized profits of multi-
ple strategies within the medium- and long-term classes, as well providing
standard errors that are robust to heteroscedasticity and autocorrelation.
Several interesting features of the profitability of trading strategies emerge
from an inspection of Table 1. First, the number of positive and negative
estimates of average profits are exactly the same; 18 versus 18. Therefore,
unconditionally, momentum and contrarian strategies are equally likely to
be successful (at least based on the 36 strategies evaluated in Table 1). This
finding is noteworthy given that momentum and contrarian strategies are
(as noted in the introduction) diametrically opposed in philosophy.
Second, 21 of the 36 trading strategies are statistically significantly prof-
itable; again the number of statistically significant contrarian versus mo-
mentum strategies is approximately the same, 11 versus 10, respectively.
Third, once we condition on the return horizon and/or the time period, how-
ever, the similarities between contrarian and momentum trading strategies
disappear. Specifically, there is a systematic relation between the horizon of
the strategy and the trading philosophy that appears to “work.” A momen-
tum strategy is usually profitable at the medium (3- to 12-month) horizons:
of the 20 medium-term strategies reported in Table 1, a momentum strategy
is profitable in 15 of the cases. More importantly, all 11 of the momen-
tum strategies that yield statistically significant profits are medium-horizon
strategies. To gauge the success of the momentum strategy at the medium
horizon, we test for the joint significance of the 3- to 12-month strategies
within each time period. Not surprisingly, there is strong evidence that the
medium-horizon momentum strategy is profitable in all time periods ex-
cept the 1926–1947 subperiod: the chi-square statistics for each of the other
four time periods have p-values of zero. During the 1926–1947 subperiod,
however, a contrarian strategy is successful at the medium horizon; the chi-
square statistic for the joint significance of the 3- to 12-month strategies has
a p-value of 0.016.

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On the other hand, the success of contrarian strategies is dependent on

one subperiod, 1926–1947. Of the 10 contrarian strategies that earn statis-
tically significant profits, four occur in the 1926–1947 period and they are
also responsible for the statistical significance of the contrarian profits of
four more strategies in the overall 1926–1989 period. More significantly, a
contrarian strategy is statistically profitable only twice in the three postwar
subperiods. We again conduct statistical tests for the joint significance of the
long-term (18- to 36-month) contrarian strategies. The chi-square statistic
for the 1926-1989 period strongly supports the profitability of the long-run
contrarian strategy with a p-value of zero, but this evidence is dependent
on one time interval, the 1926–1947 subperiod. While the p-value for the
chi-square statistic is 0.009 for the 1926–1947 subperiod, it is 0.193 for the
1948–1968 subperiod and 0.203 for the 1969–1989 period.3
Hence, the net profitability of the contrarian strategy is limited to the
long-run and to the pre-1947 data. This evidence is also consistent with the
results of Fama and French (1988) and Kim, Nelson, and Startz (1991), who
find that long-term mean reversion in the prices of portfolios of securities
is peculiar to the prewar period. Finally, although a contrarian strategy is
obviously profitable at the weekly horizon in the 1962–1989 period, recent
research shows that the profitability of short-term strategies may be spurious
because it is generated by market microstructure biases.4
The most convincing evidence in Table 1 consequently is in favor of the
momentum strategy, which provides support to proponents of the momen-
tum strategy, both on Wall Street and among academicians [see, e.g., As-
ness (1994), Grinblatt, Titman, and Wermers (1994), Jegadeesh and Titman
(1993,1995a), and Levy (1967); Hendricks, Patel, and Zeckhauser (1993)
provide related evidence]. For example, in the most recent study on trad-
ing strategies, Jegadeesh and Titman (1993) implement 32 different 3- to
12-month momentum strategies over the 1962–1989 period and find each
one to be profitable. Also, Grinblatt, Titman, and Wermers (1994) show
that about 77% of the 155 mutual funds in their sample follow momentum

3
We reestimate all the average profits in Table 1 conditional on the behavior of the market, that is, we regress
the realized profits on the market return in excess of the risk-free rate. The alphas of these regressions
are typically similar to the unconditional average profits reported in Table 1. For example, apart from
rendering the average profits of the 12-month momentum strategy statistically significant, the average
estimates of the profits of all other strategies and their statistical significance remain largely unchanged
for the overall 1926–1989 period. During the subperiods, the only notable difference is that the 24- and
36-month contrarian strategies in the 1947–1967 subperiod and the 36-month strategy in the 1968–1989
subperiod yield statistically significant conditional profits. This last result provides some support for the
Ball, Kothari, and Shanken (1995) finding that risk-adjusted contrarian profits are higher relative to the
raw profits in the postwar period.
4
Market microstructure effects (e.g., the bid-ask bounce and inventory effects) present in transaction returns
can explain significant proportions of the price reversals that lead to the apparent success of short-term
contrarian strategies [see Jegadeesh and Titman (1995b) and Conrad, Gultekin, and Kaul (1997)]. Any
remaining profits to these short-term strategies disappear at low levels of transaction costs even for large
institutional investors [see Bessembinder and Chan (1994) and Conrad, Gultekin, and Kaul (1997)].

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 The Review of Financial Studies / v 11 n 3 1998

strategies, and apparently quite successfully. Momentum is also an explicit

stock selection criterion for several mutual funds [see Bernard (1984) and
Grinblatt and Titman (1989)].5

2. Sources of Profits to Trading Strategies

In this section we provide a decomposition of the expected profits to return-
based trading strategies. Following Lehmann (1990) and Lo and MacKinlay
(1990), the profits (losses) of the trading strategies considered in the liter-
ature (and in this article) can be directly and conveniently decomposed by
taking the expectation of πt (k) in Equation (3), and again assuming that we
implement momentum strategies,

1 XN
E[πt (k)] = −Cov[Rmt (k), Rmt−1 (k)] + Cov[Rit (k), Rit−1 (k)]
N i=1
1 XN
+ [µit−1 (k) − µmt−1 (k)]2
N i=1
= −C1 (k) + O1 (k) + σ 2 [µ(k)]
= P(k) + σ 2 [µ(k)] (4)

where P(k) = −C1 (k) + O1 (k) is the predictability-profitability index,

µit (k) is the unconditional mean of security i for the interval {t − 1, t} of
PN
length k, and µmt (k) = N1 i=1 µi (k) is the unconditional single-period
mean return of the equal-weighted market portfolio at time t.
Under the assumption of mean stationarity of individual security re-
turns, the above decomposition shows that total expected profits of trading
strategies result from two distinct sources: time-series predictability in asset
returns, measured by P(k), and profits due to cross-sectional dispersion in
mean returns of securities, denoted by σ 2 [µ(k)]. The first term in P(k) is
the negative of the first-order autocovariance of the return on the equal-
weighted market portfolio, denoted by C1 (k), and is almost completely
determined by cross-serial covariances of individual security returns (see
Appendix); the second term, denoted by O1 (k), is the average of first-order
autocovariances of the N individual securities included in the zero cost
portfolio. Since P(k) is entirely determined by return predictability which,
in turn, forms the basis of all return-based trading strategies, we term it the
predictability-profitability index. Lo and MacKinlay (1990) also define an
identical profitability index. However, their motivation is to deemphasize

5
For example, past research has demonstrated the “abnormal” profitability of trading strategies that use the
Value Line “timeliness” rankings which are based on “price momentum,” determined by price performance
over the past 12 months [see Copeland and Mayers (1982) and Stickel (1985)].

498
 An Anatomy of Trading Strategies

the role of σ 2 [µ(k)] since it has a small effect on profits to trading strategies
that use weekly returns (see also Tables 2 and 4). We, on the other hand,
define P(k) to emphasize that total expected profits to return-based trading
strategies do not result entirely from time-series predictability in returns.

2.1 The random walk model

Although Equation (4) provides a convenient decomposition of expected
profits, we need a benchmark model for the return-generating process of
financial assets to interpret the two different potential sources of profits
to trading strategies. Let us assume that all security prices follow random
walks, so that returns can be depicted as
Rit (k) = µi (k) + ηit (k) i = 1, . . . , N (5)
where E[ηit (k)] = 0 ∀ i, k and E[ηit (k)η jt−1 (k)] = 0 ∀ i, j, k.6
The usefulness of the random walk model in Equation (5) as a benchmark,
particularly for this study, becomes obvious since trading strategies that rely
on time-series predictability in returns cannot be profitable by construction
because Cov[Rit (k), R jt−1 (k)] = 0 ∀ i, j, k.7 Equivalently, Equation (5)
implies that there is no return predictability in either individual securities
or across different securities, and hence the very basis of return-based trad-
ing strategies is ruled out. The model in Equation (5) also has economic
appeal as a benchmark because changes in stock prices will (generally) be
unpredictable in a risk-neutral world with an informationally efficient stock
market [see, e.g., Samuelson (1965)].
The most important property of the model in Equation (5), when com-
bined with the decomposition of total expected profits in Equation (4),
however, lies in the fact that it helps demonstrate that momentum (con-
trarian) strategies will be profitable (unprofitable) even if asset returns are
completely unpredictable. More specifically, from Equations (4) and (5) it
follows that
E[πt (k)] = σ 2 [µ(k)]. (6)
Equation (6) implies that as long as there are any cross-sectional differ-
ences in mean returns of individual securities, momentum strategies will
generate profits equal to σ 2 [µ(k)]. Conversely, contrarian strategies will
generate losses of an equal amount. Under the assumption that the mean
returns of individual securities are stationary, these profits (losses) have no
relation to any time-series predictability in returns. The “profits” in Equa-

6
Technically, all we need in our benchmark model is that the ηit ’s are uncorrelated; but for ease of exposition,
we assume a random walk model for stock prices.
7
Of course, although predictability in asset returns is a necessary condition for the success of trading
strategies considered in this article, it is not a sufficient condition for “abnormal” gains to be reaped
from these strategies. As others have pointed out, time variation in expected returns could also lead to
predictability in stock returns [see, e.g., Fama (1970, 1991)].

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The Review of Financial Studies / v 11 n 3 1998

Table 2
The decomposition of average profits to trading strategies

Strategy
interval Ê[πt (k)] P̂(k) = −ĉ1 (k) + ô1 (k) σ 2 [µ̂(k)] % P̂(k) %σ 2 [µ̂(k)]
Panel A: 1962–1989
1 week9 −0.035 −0.035 0.001 101.45 −1.45
(−23.30) (−19.95) (18.95)
3 months 0.027 −0.071 0.098 −265.92 365.92
(0.67) (−1.78) (27.22)
6 months 0.359 −0.027 0.387 −7.60 107.60
(4.55) (−0.34) (31.16)
9 months 0.708 −0.159 0.868 −22.49 112.49
(5.81) (−1.27) (32.75)
12 months 0.701 −0.849 1.550 −121.09 221.09
(4.64) (−5.44) (35.23)
18 months 0.094 −3.508 3.602 −3,747.76 3,847.76
(0.35) (−12.40) (55.41)
24 months −0.501 −7.252 6.751 1,446.91 −1,346.91
(−0.97) (−12.61) (51.93)
36 months −3.304 −21.140 17.836 639.77 −539.77
(−3.39) (−17.47) (46.08)

Panel B: 1926–1989
3 months −0.165 −0.234 0.070 142.31 −42.31
(−2.42) (−3.40) (17.95)
6 months 0.147 −0.117 0.265 −79.57 179.57
(1.91) (−1.53) (18.93)
9 months 0.488 −0.098 0.585 −20.02 120.02
(5.48) (−1.09) (20.10)
12 months 0.198 −0.870 1.069 −439.10 539.10
(1.29) (−5.32) (20.96)
18 months −0.761 −3.134 2.372 411.60 −311.60
(−2.88) (−11.00) (26.06)
24 months −1.181 −5.438 4.257 460.34 −360.34
(−2.98) (−12.36) (27.41)
36 months −4.176 −14.461 10.285 346.30 −246.30
(−6.48) (−29.61) (19.18)

Panel C1: Subperiod I (January 1926–April 1947

3 months −0.557 −0.671 0.114 120.40 −20.40
(−2.99) (−3.61) (13.57)
6 months −0.204 0.624 0.420 305.63 −205.63
(−1.03) (−3.20) (14.38)
9 months 0.276 −0.668 0.944 −242.19 342.19
(1.37) (−3.36) (16.28)
12 months −0.557 −2.489 1.932 446.54 −346.54
(−1.44) (−6.13) (18.40)
18 months −2.466 −7.033 4.567 285.16 −185.16
(−3.49) (−9.48) (22.50)
24 months −2.831 −11.250 8.419 397.42 −297.42
(−2.92) (−10.83) (26.39)
36 months −7.727 −27.882 20.155 360.84 −260.84
(−6.08) (−21.17) (40.64)

500
An Anatomy of Trading Strategies

Table 2
(continued)

Strategy
interval Ê[πt (k)]b P̂(k) = −ĉ1 (k) + ô1 (k) σ 2 [µ̂(k)] % P̂(k) %σ 2 [µ̂(k)]
Panel C2: Subperiod II (May 1947–August 1968)
3 months 0.070 +0.007 0.063 +10.17 89.83
(2.91) (0.30) (10.50)
6 months 0.333 +0.059 0.274 +17.67 82.33
(4.97) (0.88) (10.15)
9 months 0.487 −0.195 0.682 −40.16 140.16
(5.09) (−1.73) (9.61)
12 months 0.372 −0.927 1.299 −249.11 349.11
(3.80) (−5.81) (9.41)
18 months −0.117 −3.135 3.017 2,672.29 −2,572.69
(−0.77) (−10.02) (10.93)
24 months −0.434 −5.583 5.149 1,287.77 −1,187.77
(−1.62) (−10.15) (11.39)
36 months −0.922 −14.150 13.228 1,535.33 −1,435.33
(−1.24) (−7.99) (11.12)

Panel C3: Subperiod III (September 1968–December 1989)

3 months −0.020 −0.135 0.115 682.83 −582.83
(−0.43) (−3.00) (26.74)
6 months 0.273 −0.171 0.444 −62.84 162.84
(3.63) (−2.28) (29.60)
9 months 0.634 −0.321 0.955 −50.62 150.62
(5.44) (−2.68) (31.83)
12 months 0.611 −1.041 1.651 −170.44 270.44
(3.70) (−6.12) (36.69)
18 months 0.444 −3.205 3.649 −721.82 821.82
(1.51) (−4.32) (17.98)
24 months 0.792 −5.854 6.646 −739.50 839.50
(1.54) (−5.37) (20.83)
36 months −0.873 −19.363 18.490 2,217.74 −2,117.74
(−0.84) (−14.70) (37.51)
This table contains the decomposition of average profits of trading strategies using NYSE/AMEX
stocks. The decomposition of the average dollar profits is given by Ê[πt (k)] = P̂(k) + σ 2 [µ̂(k)], where
the predictability-profitability index is given by P̂(k) = −Ĉ1 (k) + Ô1 (k), Ĉ1 (k) is (approximately)
equal to the first-order autocovariance of the return of the equal-weighted portfolio of all securities
used in the zero-cost strategy, Ô1 (k) is the average first-order autocovariance of the returns of the N
individual securities in the zero-cost portfolio, and σ 2 [µ̂(k)] measures the cross-sectional variance of
the mean returns of the N individual securities. The numbers in parentheses are z-statistics that are
asymptotically N (0, 1) under the null hypothesis that the relevant parameter is zero and are robust to
heteroscedasticity and autocorrelation, and account for any cross-correlation in the realized profits and
the realized components of profits within a horizon class (short, medium, or long horizon) strategies.
All profit estimates are multiplied by 100. All profitable relative-strength strategies are shown in bold,
while all profitable contrarian strategies are in normal print.

tion (6) are realized simply because in a world where security prices follow
random walks (with drifts), following a momentum strategy amounts, on
average, to buying high-mean securities using the proceeds from the sale
of low-mean securities. That is, although a winner (loser) can have a high

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The Review of Financial Studies / v 11 n 3 1998

(low) realization of a return due to either being a high- (low-) mean security
or due to a high (low) current shock, on average winners (losers) will be
high- (low-) mean securities. Consequently, this strategy will gain from any
cross-sectional dispersion in the unconditional mean returns of the securities
included in the portfolio of winners and losers. Conversely, if a contrarian
strategy is followed, expected profits in Equation (6) will equal −σ 2 [µ(k)]:
contrarians will lose any cross-sectional variation in mean returns by on
average selling high-mean securities and buying low-mean securities with
the proceeds. These profits (losses) to trading strategies will disappear only
under the assumption that all securities have identical mean returns.
The random walk model provides economic content to the time-series
versus cross-sectional decomposition of the expected profits of return-based
trading strategies. Given that all return-based trading strategies are based
on time-series patterns in stock prices, an empirical implementation of the
decomposition will help us determine the legitimacy of this fundamental
premise of trading strategies. Note that if one were to assume that cross-
sectional differences in mean returns are due entirely to differences in risk
characteristics—a viewpoint not uncommon even among proponents of
the return-based trading strategies [see, e.g., Jegadeesh and Titman (1993,
1995a) and Lehmann (1990)]—the empirical decomposition will help pro-
vide deeper insights into the potential efficiency or inefficiency of asset
prices.
Table 2 contains estimates of the total average profits, Ê[πt (k)], and its
two components, P̂(k) and σ 2 [µ̂(k)], for all holding periods, k, and for all
five time periods, 1962–1989 (panel A), 1926–1989 (panel B), and the three
subperiods (panels C1–C3). The numbers in parentheses below Ê[πt (k)],
P̂(k), and σ 2 [µ̂(k)] are their respective z-statistics, which are autocorrela-
tion and heteroscedasticity consistent and take into account cross-sectional
correlations in the realized profit of all strategies among each holding-period
class. The Appendix contains the exact formulae and procedures used to
estimate each of the three components of total average profits.
Since the empirical decomposition of the profits is critically dependent
on estimates of the unconditional means of the returns of individual secu-
rities, it is important to note again that the components are estimated under
the assumption that the unconditional mean return of each security is con-
stant over the entire sample period under consideration. We estimate the
unconditional means using all data in a particular time period, and calculate
the components of the profits of a particular strategy in a particular period
based only on the securities included in that strategy in that specific period.
In addition, we conduct subperiod analyses to evaluate the effect of our
strong mean stationarity assumption on our inferences; the inferences re-
main largely unchanged. We use overlapping data to minimize small-sample
biases in estimates of the components of profits to trading strategies, but we

502
An Anatomy of Trading Strategies

recognize that measurement errors in in-sample mean returns could nev-

ertheless affect our inferences (see Appendix). Consequently, we devote
Section 3 entirely to empirically evaluate the extent to which measurement
errors may affect our results and inferences. Clearly, since there are rela-
tively few long-horizon (say 3-year) returns even in the 1926–1989 period,
the decomposition results for the long-horizon strategies should be inter-
preted with special caution.
The first important aspect of the results in Table 2 is the significant effect
of the cross-sectional variance of mean returns, σ 2 [µ̂(k)], on the profits
of all trading strategies. Specifically, the cross-sectional component of the
profits is both the predominant source of profits to the momentum strategy
at medium horizons, and a major source of losses to contrarian strategies at
long horizons. Note that the σ 2 [µ̂(k)]’s are always statistically significantly
greater than zero.
To gauge the economic role of the cross-sectional dispersion in mean
returns in determining the profits of the different trading strategies, con-
sider first the dramatic increase in the absolute magnitude of σ 2 [µ̂(k)] with
the investment horizon in each of the five sample periods. This finding is
important to emphasize because a similar pattern would be observed in the
data if security prices follow the random walk process in Equation (5) or,
equivalently, even if there is no predictability in returns. Specifically, given
Equation (5), the expected profits from a momentum strategy applied to a
trading horizon of k periods and continuously compounded returns is given
by [see Equation (6)]

E[πt (k)] = k 2 σ 2 [µ(1)] = k 2 E[πt (1)]. (8)

Equation (8) shows that the expected profits (losses) from a momentum
(contrarian) strategy will increase geometrically with the holding period k
because the cross-sectional dispersion of mean returns increases with the
(square of the) length of the holding period (relative to the length of the
base holding period). For example, given Equation (5), the cross-sectional
dispersion of the means of 36-month holding period returns will be 144
times [i.e., (36/3)2 times] the cross-sectional dispersion of the means of
3-month holding period returns. An inspection of the estimates of σ 2 [µ(k)]
in Table 2 shows that they do increase dramatically with the investment
horizon in each sample period.
This finding suggests that the profitability of momentum strategies at
medium horizons may not be due to price continuations potentially in-
duced by market inefficiencies. Moreover, the lack of statistically prof-
itable contrarian strategies may be because these strategies lose the cross-
sectional dispersion in means, with this loss being particularly severe at long
horizons.

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2.2 Momentum strategies

Recall that the momentum strategy is usually profitable at medium horizons.
To evaluate the relative importance of the cross-sectional versus time-series
sources of these profits, however, it is instructive to evaluate the percentage
contributions of P̂(k) and σ 2 [µ̂(k)] to total profits, as well as the sign and
statistical significance of the P̂(k)’s. Note that if stock prices follow random
walks, the percentage contributions of σ 2 [µ(k)] should be constant and
equal to 100% [see Equation (6)]. The evidence in Table 2 demonstrates the
important role of the cross-sectional variation in mean returns, as opposed
to time-series patterns in security prices, in determining the profitability of
momentum strategies. Of the 18 cases in which positive profits are observed
for momentum strategies (see estimates in bold in Table 2), the percentage
contributions of σ 2 [µ̂(k)] are typically greater than 100%. There are only
two occasions on which the contribution of the cross-sectional dispersion
in mean returns to momentum strategies is less than 100%: the 3-month and
the 6-month strategies in subperiod II, panel C.2. Even in these two cases,
however, the contribution of σ 2 [µ̂(k)] is over 80%.
An alternative way to evaluate the relative importance of the cross-
sectional versus time-series components of the profits of momentum strate-
gies is to note that there are only two instances in which these strategies gain
from continuations in asset prices, that is, the P̂(k)’s are positive. These are
(obviously) the same two cases mentioned above. However, an advantage
of evaluating the relative contribution of P̂(k) is that we can also determine
the statistical significance of any profits to trading strategies due to pre-
dictable time-series patterns in asset prices. The evidence shows that even
in the two cases which benefit from price continuations, the resulting profits
are statistically indistinguishable from zero. Using our particular method
of decomposing profits, the statistical significance of medium-horizon mo-
mentum profits appears to emanate from the statistical significance of the
σ 2 [µ̂(k)]’s. Given that this empirical decomposition is affected by measure-
ment errors in mean returns, however, our inferences at this stage should be
treated with caution.

2.3 Contrarian strategies

The importance of the cross-sectional dispersion in mean returns in de-
termining the profitability of trading strategies is again observed in cases
where a contrarian strategy appears to “work.” Note that barring the weekly
and the 3-month strategies, the σ 2 [µ̂(k)]’s lead to substantial losses to con-
trarian strategies. For example, even in the seven long-term strategies that
yield statistically significant profits to a contrarian strategy, the losses due
to cross-sectional dispersion in mean returns are larger than the net profits.
The important role of σ 2 [µ(k)] is also exemplified by the fact that there
are statistically significant profits due to the price reversals in stock prices,

504
 An Anatomy of Trading Strategies

especially at longer horizons, yet only a few strategies yield statistically

significant net contrarian profits. Specifically, the P̂(k)’s are statistically
significantly negative for all long-term (18- to 36-month) strategies. Yet
only in less than half the cases (7 of the 15 long-term strategies) are the
price reversals able to overwhelm the losses from the cross-sectional vari-
ance in mean returns and lead to statistically significant net profits. All of this
evidence appears to be an outcome of severe and unusual price movements
during the 1926–1947 subperiod.

3. Robustness Tests: Some Simulations8

Our analysis, based on the decomposition of the profits of trading strategies,
suggests that the main determinant of the profits of return-based trading
strategies is the cross-sectional variation in mean returns. Contrary to the
commonly held belief that forms the basis of return-based strategies, the
evidence suggests that time-series patterns in security returns are unlikely
to result in statistically significant net profits to trading strategies.
The decomposition of the trading profits in Table 2 is based, however,
on two assumptions. First, the mean returns of individual securities are as-
sumed to be constant over the period in which the trading strategies are im-
plemented. Second, the cross-sectional distribution of the in-sample mean
returns accurately measure the true cross-sectional variation in the mean
returns. While we do not allow for time-varying mean returns that could
potentially explain predictability in returns, we do attempt to address the po-
tentially serious effects of measurement errors in in-sample mean returns by
conducting several simulation exercises and providing additional evidence
about the potential role of the cross-sectional differences in mean returns.
The main purpose of the simulations is to analyze the profitability of
trading strategies using simulated returns that are devoid of any time-series
patterns that may be present in the real data, while maintaining the cross-
sectional characteristics of each security. Conducting simulations of any
trading strategy, however, involves a great deal of time and computer re-
sources, since the returns of several thousand individual securities need to be
simulated. Consequently, we chose to simulate the profits of medium-term
trading strategies during the 1964–1989 period. We chose the medium-term
strategies because they are usually profitable in the “real” data; we focus
on the 1964–1989 period because momentum strategies are most profitable
during this subperiod.
We first implement the medium-term trading strategies on real data dur-
ing the 1964–1989 period. The second column of Table 3 contains the av-

8
We thank Ravi Jagannathan for recommending the use of simulations as a robustness check for our
empirical decomposition.

505
 The Review of Financial Studies / v 11 n 3 1998

erage profits, with their heteroscedasticity- and autocorrelation-consistent

z-statistics in parentheses, for the 3- to 12-month strategies. Not surprisingly,
the profit estimates are virtually identical to the profits for the 1962–1989
sample period in Table 2, panel A.

3.1 Bootstrap results

To gauge whether the cross-sectional variance in mean returns alone can
generate the profits to medium-horizon strategies, we first conduct bootstrap
simulations in which the returns of individual securities are “scrambled” in
an attempt to eliminate any time-series relations that may be present in
the real data [see Efron (1979)]. Specifically, we generate a sample of 301
monthly returns for each stock in the sample by resampling with replacement
from the actual monthly returns between (December) 1964 and (December)
1989. This bootstrap sample should eliminate any time-series properties
in each security’s returns, while maintaining all the other characteristics.
Specifically, the cross-sectional distribution of the individual-security mean
returns should be preserved. In re-creating the bootstrap sample, we preserve
the missing observations because that helps us retain the exact sample size
used in the actual trading strategy.9
All medium-term (3- to 12-month) strategies are implemented on the
bootstrap sample, and this exercise is replicated on 500 bootstrapped sam-
ples. Table 3, panel A, contains the results from the bootstrap simulations.
The first column of panel A contains the average profits of the trading
strategies, the second column contains the average t-statistics of the 500
replications, and the last column shows the p-values which measure the
proportion of times the simulated mean returns are greater than the mean
returns of the actual strategies shown in the second column of Table 3.
The bootstrap results confirm the findings of our decomposition anal-
ysis. The mean profits of the bootstrap strategies are always greater than
the corresponding estimates in panel A and the p-values are large, rang-
ing between 0.69 and 1.00. Moreover, the average t-statistics of all the
medium-term bootstrap strategies are greater than 10 and each of the t-
values are significant for each strategy in all the 500 replications.10 These
results suggest that the cross-sectional properties of the returns observed

9
To maintain the cross-sectional correlation in the returns, in one of our bootstrap experiments we attempted
to scramble entire vectors of returns. This created a substantial mismatch between the number of securities
used in the actual trading strategy and the simulated strategy, since the resampling of vectors scrambled
the missing values as well. The substantial reduction in the number of securities in the simulated sample
rendered the simulated and the actual samples incomparable. Consequently, we chose to preserve the
placement of missing values in scrambling the individual security returns and thus maintain the same set
of securities in the simulations that are used in the actual strategy.
10
The average t-values in Table 3, panel A, are always substantially larger than the corresponding t-values
of the profits of the actual strategies because of a lack of cross-sectional correlation in the bootstrapped
sample.

506
 Table 3
Average profits of actual and simulated medium-term trading strategies

Strategy Ê[πt (k)] Ê[πt (k)] t p Ê[πt (k)] t p Ê[πt (k)] t p Ê[πt (k)] t p Ê[πt (k)] t p
Interval
Panel A Panel B Panel C Panel D Panel E
3 months 0.0217 0.0988 11.19 1.00 0.1026 10.93 1.00 0.0935 10.92 1.00 0.0721 8.87 1.00 0.0015 0.16 0.05
(0.60)
6 months 0.3512 0.3775 17.53 0.69 0.4041 15.56 0.82 0.3655 16.90 0.60 0.2913 14.81 0.07 0.0069 0.26 0.00
(4.52)
An Anatomy of Trading Strategies

9 months 0.7199 0.8411 21.21 0.88 0.9220 17.96 0.88 0.8093 20.34 0.80 0.6608 18.96 0.24 0.0127 0.07 0.00
(5.83)
12 months 0.7183 1.4704 24.20 1.00 1.5944 20.06 1.00 1.4345 22.44 1.00 1.1956 21.93 1.00 0.0144 0.07 0.00
(4.63)
This table contains average actual and average simulated profits to zero-cost trading strategies that buy NYSE/AMEX winners and sell losers based on their past
PN
performance relative to the performance of an equal-weighted index of all stocks. The dollar profits are given by πt (k) = w (k)Rit (k) i = 1, . . . , N ,
i=1 it−1 PN
where πt (k) is the dollar profit at time t from a k-period trading strategy, wit−1 (k) = N1 [Rit−1 (k) − Rmt−1 (k)] and Rmt−1 (k) = N1 R (k). The
i=1 it−1
second column contains estimates of average profits of medium-term momentum strategies implemented on the real data from December 1964 to December
1985. The numbers in parentheses are z-statistics that are asymptotically N (0, 1) under the null hypothesis that “true” profits are zero and are robust to
heteroscedasticity and autocorrelation. The table also contains results of several simulations, each with 500 replications. Panel A contains a bootstrap
simulation in which we generate 1-month returns from the sample with replacement and then implement the four medium-term (3- to 12-month) momentum
strategies. The panel also contains the t-statistics average of the 500 simulated t-values and the p-values, where these values denote the proportion of times
the 500 simulated mean returns are greater than the sample mean profits of the actual strategy shown in the second column. Panels B–E contain Monte Carlo
simulations. In Panel B we show average profits, average t-values, and the p-values of implementing the trading strategies on randomly sampled 1-month
individual security returns from normal distributions that have moments (means and variances) that match the monthly moments of the securities in the
sample. Panels C and D contain estimates for trading strategies implemented on randomly sampled monthly returns generated from normal distributions that
exclude the “extreme” 1% and 5%, respectively, of the high- and low-mean securities. Panel E provides the average profits, average t-values, and p-values of
trading strategies implemented on randomly sampled firms from normal distributions with identical means but variances that match the sample counterparts.
All profit estimates are multiplied by 100.

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 The Review of Financial Studies / v 11 n 3 1998

between 1964 and 1989 alone have the potential to explain the profits of
momentum strategies.11
An interesting and important aspect of the bootstrap results is the relation
between the average profits of the momentum strategies and their holding
periods. Specifically, consistent with the prediction of the random walk
model, the profits increase geometrically with the holding period, k [see
Equation (8) and the discussion in Section 2.2]. Given the mean returns
for the basic monthly measurement interval (i.e., for k = 1), the relation
between the average profits of the 3-month versus the 6-month and 12-
month strategies is virtually identical to the predictions of the random walk
model: starting with an average profit of 0.099 for the 3-month strategy,
there is a geometric increase to 0.378, 0.841, and 1.470 for the 6-, 9-, and
12-month strategies, respectively. This is in sharp contrast for the average
profits for the real strategies reported in the second column, which increase
with the holding period, but less than geometrically, and eventually exhibit
no change between the 9- and 12-month strategies. This behavior in turn
suggests the presence of price reversals, and not momentum, in the real data.
The bootstrap results appear to confirm the findings of the empirical
decomposition of the real profits presented in Table 2. Since we do not
estimate any parameters of individual-security returns in the bootstrap tests,
these results should be devoid of measurement errors in mean returns present
in the empirical decomposition.

3.2 Monte Carlo evidence

We also conduct Monte Carlo simulations in which returns of individual
securities are sampled from normal, independent, and identical distributions
with moments that match the moments of the securities used in the trading
strategy. We conduct these experiments for two reasons: (i) to ensure that
individual security returns do not contain any time-series correlations, and
(ii) to check the sensitivity of the empirical decomposition in Table 2 to
measurement errors in mean returns (or specifically to the “extreme” mean
returns observed in the real data).

11
Note that all estimates in Tables 2 and 3 are profits and not returns because the strategies are zero-
investment strategies [see Equation (2a)]. Under the null hypothesis that stock returns follow random
walks, however, the profits from the actual and simulated strategies are directly comparable. This follows
because the expected value of dollar investment long (or short) [see Equation (2b)] is the same since it
depends on the unconditional means of the returns which, in turn, are the same in the actual and each of
the simulated strategies.
Karolyi and Kho (1993) also conduct bootstrap and Monte Carlo experiments on momentum strategies.
They simulate or shuffle monthly returns to examine 6-month strategies and, like Jegadeesh and Titman
(1993), rank stocks on the basis of past returns and buy (sell) equal-weighted decile portfolios of the
highest (lowest) return securities. Although this portfolio method differs from ours, their results also
suggest that cross-sectional variation in mean returns is important—they find that the average profits of
the simulated zero-investment strategy, though less than the actual profits, still constitute about 80% of
profits in the real data. Recall that we do not implement the Jegadeesh and Titman (1993) strategy because
it does not lend itself readily to the decomposition analysis that is our main focus [see the discussion in
Section 1].

508
An Anatomy of Trading Strategies

In the Monte Carlo simulations we generate 1-month individual security

returns from independent and identical normal distributions that have means
and variances that are identical to those observed in the real data. We simu-
late 500 such monthly series and implement the momentum trading strategy
for the 3- to 12-month intervals for each set of returns. Table 3, panel B,
contains the average profits, the average t-statistics, and the p-values de-
noting the proportion of times the 500 simulated mean returns are greater
than the corresponding sample mean returns in the second column of the
table. The results of this Monte Carlo experiment are similar to the bootstrap
evidence in panel A. The mean profits are all greater than those witnessed
in the real data, and the p-values range between 0.82 and 1.00, suggesting
that the cross-sectional characteristics of the data could generate the profits
of the momentum strategies. And again, the difference between the average
profits of the simulated and real strategies increases significantly with an
increase in the holding period, implying that there are reversals in the real
data at least at the 9- and 12-month horizons.
The Monte Carlo simulations therefore suggest that in-sample cross-
sectional differences in individual security returns can account for the prof-
itability of medium-term momentum strategies. To determine the robustness
of the profitability of the simulated strategies to “extreme” mean returns
observed in the data, we conduct two additional Monte Carlo experiments.
In these two simulations, we exclude individual securities that have ex-
treme means (both positive and negative) from the entire simulated sam-
ples, that is, we exclude 1% and 5%, respectively, of the securities based
on the magnitudes of their estimated mean returns. This has the effect of
reducing the estimated cross-sectional variance of mean returns of indi-
vidual securities. It also provides a means of checking the sensitivity of
our results to estimation error in the mean returns, since it is possible that
the extreme means of individual security returns observed in the real data
are an outcome of measurement errors rather than being “true” extreme
means.
Ideally a calibration of the underlying cross-sectional distribution of
mean returns should be determined by an asset pricing model. However,
given the lack of success of theoretical asset pricing models like the CAPM
to explain the cross-section of required returns, we do not attempt such an
exercise. Our simulation analysis is similar in spirit to the work of Knez
and Ready (1997), who show that the “size effect” can be explained by 1%
of the “outliers” in the data.
The evidence from the Monte Carlo experiments that exclude 1% and 5%
of the extreme-mean securities is shown in Table 3, panels C and D, respec-
tively. These results show that excluding 1% and 5% of the extreme-mean
securities from the simulation lowers the average profits at all horizons, but
it does not change the basic conclusion that the success of the momentum
strategies can be accounted for by cross-sectional differences in mean re-

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 The Review of Financial Studies / v 11 n 3 1998

turns of individual securities. In panel C, none of the mean profits are less
than the corresponding real numbers reported in the second column of the
table, and the p-values remain large, ranging from 0.60 to 1.00. In panel D,
the mean profits are about 20% and 10% lower than the real profits for the
6- and 9-month strategies, respectively, but the p-values remain relatively
high at 0.07 and 0.24. For the 3- and 12-month strategies the average sim-
ulated profits are substantially higher than the corresponding real profits,
with p-values of 1.00.
Finally, we attempt to determine whether there are any biases inherent in
the Monte Carlo simulations by simulating individual security returns that
have the same variances as the real data, but have identical (zero) means and
no time-series relations. We again simulate 500 series of monthly returns for
all the securities in our sample and implement the medium-term momentum
strategies. The results of this experiment are shown in Table 3, panel E. The
profits are invariably positive due to “noise,” but the magnitudes of the
average profits are small: 0.0015, 0.0069, 0.0127, and 0.0144 for the 3- to
12-month strategies, respectively. Also, the p-values are all close to zero.
These estimates are between 0.90% and 1.71% of the corresponding Monte
Carlo estimates in panel B, which reflect all the in-sample cross-sectional
variation in mean returns. Moreover, the average t-statistics are also small,
ranging between 0.073 and 0.259. Hence, the biases in the simulations
appear to have a minor effect on the inferences because the profitability of
trading strategies is very small if there is no cross-sectional variation in the
mean returns of individual securities.12

3.3 Some additional evidence and interpretation

The empirical decomposition and the simulation evidence suggest that
cross-sectional differences in mean returns could play an important role
in determining the profitability of return-based trading strategies. In this
section, we provide some additional evidence and interpretation that may
shed more light on this issue.
The problem with the empirical decomposition is that it is based on
estimates of the mean returns of individual securities that are measured with
error in finite samples (see Appendix). The small-sample bias is potentially
important, especially for longer horizons because we use k-period returns

12
We conduct another set of tests to check the robustness of our findings. Specifically we sort securities
based on their betas before implementing the trading strategies. The profits of strategies implemented on
securities sorted by beta should reduce the cross-sectional variation in mean returns, σ 2 [µ(k)], and should
also simultaneously increase our ability to highlight or emphasize the role (if any) of price continuations or
reversals in generating profits for trading strategies. The most important general finding for the beta-sorted
strategies is that, although there is a substantial reduction in the point estimates of the cross-sectional
dispersion in mean returns for most holding periods, σ 2 [µ̂(k)] continues to have an important effect on the
profits of trading strategies. The contribution of σ 2 [µ̂(k)] is again always statistically different from zero.
Moreover, as in Table 2, σ 2 [µ̂(k)] contributes high percentages of the profits of momentum strategies and
it also continues to result in large losses to contrarian strategies.

510
An Anatomy of Trading Strategies

to calculate the k-period mean returns (that is, 12-month returns are used
to calculate 12-month mean returns). To assess the effects of small samples
on the empirical decomposition of trading profits presented in Table 2, we
now provide estimates of the cross-sectional variance in mean returns for
all horizons in italics by alternative estimates of the cross-sectional variance
in weekly mean returns. Since the number of weekly observations are large
(up to 1,434 for the 1962–1989 period), the effects of measurement errors
in mean returns on estimates of the cross-sectional variance in mean returns
should be small (see Appendix). The implied estimate of the cross-sectional
variance in mean returns for different horizons are calculated using the
following formula [see Equation (8)]:

σ 2 [µ̂(k)] = n 2 σ 2 [µ̂(weekly)] (9)

where n is the number of weeks in the holding period, k, of the trading

strategy (k = 3 months, . . . , 36 months). The implied cross-sectional vari-
ances in Equation (9) are obtained under the assumption that returns follow
stationary processes.
We use three alternative samples to calculate the weekly cross-sectional
variance in mean returns used in Equation (9). The first sample is the
“survivor-sample” of 512 firms that have no missing weekly returns during
the entire 1962–1989 period. The cross-sectional variance in mean returns
of these firms is likely to have little bias since each firm’s mean return is
calculated using 1,434 observations (see Appendix). The weekly estimate
of the cross-sectional variance reported in Table 4 is 0.000087, which is
virtually identical to the estimate of 0.00009 reported in Lo and Mackinlay
(1990) based on a sample of 551 survived firms for the 1962–1987 period,
each with 1,330 observations. Although the cross-sectional variance of the
mean returns of firms in this sample is likely to be measured with reasonable
accuracy, it is also likely to provide a “lower bound” on the cross-sectional
variance of the mean returns of the firms used in our trading strategies. Firms
that survive the entire sample are likely to be large firms with similar mean
returns and, in any event, a “real time” trading strategy could not be imple-
mented on such a set of survived firms. The second sample of firms used to
calculate the weekly cross-sectional variance in mean returns is the “limited
sample” of 2,111 firms that have transaction prices for at least half (that is,
717 weeks) of the sample period. The bias in the cross-sectional variance
of the mean returns of the individual securities in this sample should also
be relatively small. On the other hand, however, the “true” cross-sectional
variance in mean returns in this sample should again be less than the sample
of firms used in the trading strategies. The estimated cross-sectional vari-
ance in mean returns of this sample (see Table 4) is 0.000140, which is 60%
larger than the corresponding estimate for the “survived sample.” Some of
this increase may be due to the increased effects of measurement errors,

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Table 4
Implied cross-sectional variation in mean returns for different
horizons based on weekly estimates

Survivor Limited All firms

Strategy interval firms firms (N = 6,524)
(N = 512) (N = 2,111)
1 week 0.000087 0.000140 0.000535
3 months 0.014703 0.023660 0.090415
(21,56) (34,89) (129,333)
6 months 0.058812 0.094640 0.361660
(16,40) (26,64) (100,246)
9 months 0.132327 0.212940 0.813735
(19,48) (30,77) (115,295)
12 months 0.235248 0.378560 1.446640
(34,119) (54,191) (207,732)
This table contains the implied cross-sectional variation in mean
returns for trading strategies of different horizons based on weekly
estimates for three alternative samples. The weekly cross-sectional
variation of the “survivor-firm” sample is based on a set of 512
firms that have no missing returns during the 1962–1989 period,
and each individual-security’s mean return is calculated using 1,434
observations. The cross-sectional variation of the “limited-firm”
sample is based on a set of 2,111 firms that had a minimum of
717 returns during the 1962–1989 period, while the estimate for
the “all firm” sample is based on all 6,524 firms that are included
in the trading strategy reported in Table 1. The implied estimates
of the cross-sectional variation in mean returns are obtained as
σ 2 [µ̂(k)] = n 2 σ 2 [µ̂(week)], where n is the number of weeks in
the holding period, k, of the trading strategy. All estimates of the
cross-sectional variation in weekly mean returns are multiplied by
100. The numbers in parentheses below the implied estimates of
the cross-sectional variation in mean returns are the minimum and
maximum percentages of the profits of trading strategies reported
in Table 1 for different time periods that can be explained by the
implied estimates.

but some of it is likely to be due to larger differences in the “true” means

of individual securities. The third weekly estimate of the cross-sectional
variance in mean returns is 0.000535, which is for the “all-firm” sample of
6,524 firms used in the actual weekly trading strategy reported in Table 1.
This estimate is six (four) times larger than the corresponding estimate for
the “survived sample” (“limited sample”).
Table 4 contains the implied cross-sectional variances in mean returns
for all three samples of firms for the medium horizons (3 to 12 months).
We do not report the implied estimates for the long horizons (18 to 36
months) because, even without adjusting for the cross-sectional variation
in mean returns, there appear to be reversals in the long run. The numbers
in parentheses below the implied cross-sectional variance in mean returns
are the minimum and maximum percentages of the actual profits of trading
strategies reported in Table 1 that can be explained by them. For example, the
implied cross-sectional variances of 0.094640 at the 6-month horizon for the
“limited-firm” sample can explain a minimum of 26% of the profits of the

512
 An Anatomy of Trading Strategies

6-month momentum strategy in the 1962–1989 period, and a maximum of

64% of the profits of the 6-month trading strategy in the 1926–1989 period.
The results in Table 4 shed some light on the relative importance of the
cross-sectional variance in mean returns in determining the profitability of
trading strategies. Consider the most conservative estimates of the cross-
sectional variation in mean returns based on the “survived sample.” The
implied cross-sectional variance can explain between 16% and 119% of
medium horizon strategies implemented over the various time periods. The
corresponding percentages are 26% and 191% for the “limited-firms” sam-
ple. Finally, the implied cross-sectional variation in mean returns for the
“all-firms” sample is sufficient to explain the profits of all medium-horizon
strategies. Hence, even if we rely solely on the most conservative estimates
in Table 4, the evidence suggests that cross-sectional differences in the mean
returns of securities included in trading strategies could play a nontrivial
role in determining the profitability of these strategies.

4. Conclusion
We present an analysis of trading strategies that rely on time-series pat-
terns in security returns. We implement the two most commonly suggested
strategies—momentum and contrarian—at eight different horizons and dur-
ing several different time periods. We show that less than 50% of the 120
strategies implemented in this article yield statistically significant profits
and, unconditionally, momentum and contrarian strategies are equally likely
to be successful. However, there are two systematic patterns that emerge.
First, the momentum strategy usually nets positive and statistically signif-
icant profits at medium horizons, except during the 1926–1947 subperiod.
Second, the contrarian strategy is successful at long horizons, but the prof-
its to these strategies are statistically significant only during the 1926–1947
subperiod.
We find that an important determinant of the profitability of trading strate-
gies is the estimated cross-sectional dispersion in the mean returns of indi-
vidual securities comprising the portfolios used to implement these strate-
gies. This cross-sectional variance is not related to the time-series patterns in
returns that form the basis of return-based trading strategies. Specifically, the
cross-sectional dispersion in mean returns witnessed during different time
periods can potentially generate the observed profits of the most consis-
tently profitable strategy, the momentum strategy implemented at medium
horizons. Our findings, based on the empirical decomposition of profits,
bootstrap and Monte Carlo simulations, and alternative estimates based on
weekly returns, suggest that cross-sectional differences in mean returns play
a nontrivial role in determining the profitability of momentum strategies.
On the other hand, although there is substantial and statistically reliable
evidence of price reversals, the net profits to contrarian strategies are statis-

513
 The Review of Financial Studies / v 11 n 3 1998

tically significant primarily during one subperiod: 1926–1947. In all other

subperiods, the consistently significant profits from price reversals are (sta-
tistically) neutralized at least in part by the losses due to the cross-sectional
dispersion in the mean returns of securities included in the strategy. These
losses again appear to have no relation to time-series patterns in security
returns that form the basis of trading strategies; they occur because a con-
trarian strategy on average involves the purchase of low-mean securities
from the proceeds of the sale of high-mean securities.
The results of our article are clearly dependent on the assumption that
the mean returns of individual securities are constant during the periods in
which the trading strategies are implemented. However, our results raise
the intriguing possibility that the cross-sectional variation in mean returns
can simultaneously account for the profits of momentum strategies and the
typical lack of success of contrarian strategies. This finding in itself may
raise questions about the profitability of trading strategies and the related,
and more significant, issue about the informational efficiency of stock prices.
Obviously, different specifications of the model for unconditional required
returns could affect the conclusions of our analysis. Several recent attempts
at explaining the momentum effect are being made along these lines, but with
mixed results [see, e.g., Fama and French (1996) and Moskowitz (1997)]. It
is also possible that more plausible models of time-varying expected returns
could provide deeper insights into the potential sources of the profits of
momentum strategies [see, e.g., Grundy and Martin (1997) and Karolyi and
Kho (1993)].

Appendix
A.1 Estimation of the components of profits
The components of total profits [see Equation (4)] are estimated by allowing
serial covariances (both own and cross) and the cross-sectional variance of
mean returns of individual securities to be time dependent. Specifically,

1 X
T (k)
Ĉ1 (k) = C1t (k),
T (k) − 1 t (k)=2

where

1 X
N
C1t = Rmt (k)Rmt−1 (k) − µ̂2mt−1 (k) − 2 [Rit (k)Rit−1 (k) − µ̂it−1
2
(k)]
N i=1

1 X
T (k)
Ô1 (k) = O1t (k),
T (k) − 1 t (k)=2

514
An Anatomy of Trading Strategies

where

N −1X N
2(k)
O1t = [Rit (k)Rit−1 (k) − µ̂it−1 (k)]
N 2 i=1

and

1 X
T (k)
σ 2 [µ̂(k)] = σ 2 (k),
T (k) − 1 t (k)=2 t

where

1 XN
σt2 (k) = [µ̂it−1 (k) − µ̂mt−1 (k)]2
N i=1

and T (k) = total number of overlapping returns in the sample period for
a trading strategy based on holding period k. For ease of exposition, we
do not have a security-related subscript on T (k), but each security in the
trading strategy will have a different number of observations.
In calculating the components of the profits to trading strategies, we as-
sume that individual security returns are mean stationary, and we calculate
all sample means of security returns for each holding period k, µ̂i (k), us-
ing overlapping data over the entire sample period. The t − 1 subscript on
µ̂it−1 (k) and µ̂mt−1 (k) simply denotes that these are the sample means of
securities available at time t − 1 to form the trading strategy portfolios [see
Equation (1)]. The only reason the mean returns of individual securities
change at each portfolio formation time t − 1 is because the securities in-
cluded in each strategy in each period themselves change and, consequently,
the mean return of the portfolio of all these securities, µ̂m (k), also changes.
Therefore, although we require mean stationarity, estimates of all compo-
nents of the profits/losses of trading strategies are time dependent. The use
of the entire sample period to calculate the mean returns of individual se-
curities, as opposed to calculating the means based on a rolling sample of
data up to time t − 1, should reduce the estimates of the cross-sectional
variance in mean returns because each mean is estimated more precisely.
The assumption of mean stationarity does not appear to affect our main
inferences because they are robust across different sample periods.
Finally, note that the minor differences between the population param-
eters C1 (k) and O1 (k) in Equation (4) and their sample counterparts are
reflected above in the last element of C1t (k) and the NN−1 2 factor in O1t (k).
The estimators are calculated slightly differently so that Ĉ1 (k) depends en-
tirely on cross-serial covariances, while Ô1 (k) depends solely on own-serial
covariances [see also Lo and MacKinlay (1990)].

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The Review of Financial Studies / v 11 n 3 1998

A.2 Small-sample biases in estimators of the components of profits

It can be shown that since sample means are estimated with error in small
samples, covariance estimators are downward biased [see Fuller (1976)].
Consequently, the estimators of the components of total profits [see Equation
(4)] are biased in small samples. Specifically,
σmt−1
2
(k)
E[Ĉ1 (k)] ' C1 (k) − ,
T (k)
1 PN
i=1 σit−1 (k)
2
E[ Ô1 (k)] ' O1 (k) − N
,
T (k)
1 PN
i=1 σit−1 (k) σ 2 (k)
2
and E[σ [µ̂(k)]] ' σ [µ(k)] +
2 2 N
− mt−1 ,
T (k) T (k)
where T (k) is the number of returns of holding period k used to calculate
trading profits, σi2 is the population variance of an individual security’s
return, and σm2 is the population variance of the return of the equal-weighted
portfolio of all securities used in the trading strategy portfolio. Finally, it is
important to note that all the small-sample biases noted above are derived
under the null hypothesis that returns are independently and identically
distributed.
An interesting aspect of the above analysis is that the biases in the com-
ponents offset each other. Also, note that Ĉ1 (k) and Ô1 (k) are downward
PN
biased, but since N1 i=1 σit−1
2
> σmt−1
2
, the downward bias in Ô1 (k)
is greater than the downward bias in Ĉ1 (k). For a momentum strategy,
therefore, in small samples σ 2 [µ̂(k)] will be upward biased while the
predictability-profitability index, P̂(k), will be downward biased by the
same magnitude. This bias could be nontrivial in small samples which,
in turn, could materially affect inferences about the relative importance
of the sources of profits to trading strategies. Since the bias disappears as
T (k) → ∞, however, we use overlapping holding period returns at the
monthly frequency for each trading strategy (except the 1-week strategy). It
is important to note that the entire discussion of the small-sample biases is
based on the assumption that “true” returns are serially uncorrelated. This
assumption will result in an over- (or under-) estimate of the bias if returns
are negatively (positively) serially correlated. Since measurement errors are
likely to have some effects on our references even using overlapping data,
we address this issue in several alternative ways in Section 3 of the article.

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