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Long-Term Return Reversals: Overreaction or Taxes By Thomas J. George and Chuan-Yang Hwang

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. Purpose of the study: Testing alternative hypotheses for explaining long-term reversals in stock returns:

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Long-Term Return Reversals: Overreaction or Taxes By Thomas J. George and Chuan-Yang Hwang

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

  2. Outline of the study • Purpose of the study: Testing alternative hypotheses for explaining long-term reversals in stock returns: • Overreaction Hypothesis • Investors make systematic mistakes when they react to information. • Predicts that both winners and losers reverse. • Capital Gains Lock-in Hypothesis • 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).

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

  4. Outline of the study • Method: • 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: • 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.

  5. Outline of the study • Contributions of the study • 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)

  6. Suggestions • Very interesting and well written paper. • Robustness check: • 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 • alternative explanations for the result? • Other factors explaining the asymmetry?

  7. Suggestions • Odean (1998) vs. CGLI hypothesis • 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.

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

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