Academic journal article Financial Services Review

The Overlooked Momentum Traders in 401(k) Plans

Academic journal article Financial Services Review

The Overlooked Momentum Traders in 401(k) Plans

Article excerpt

(ProQuest: ... denotes formulae omitted.)

1. Introduction

Momentum trading is a trading strategy whereby investors buy past winners and sell past losers. Numerous studies point out that a hypothetical investor who follows momentum trading strategy can generate significant positive returns in the short term (see, e.g., Jegadeesh and Tittman, 1993, 2001; Rouwenhorst, 1998). Performance persistence in mutual funds further confirms the possibility of realizing abnormal return by chasing past winner funds (Goetzmann and Ibbotson, 1994; Grinblatt and Titman, 1992; Hendricks et al., 1993). Consequently, many portfolio managers, institutional and individual stock investors, and mutual fund traders subscribe to the view that momentum strategies yield significant profits and follow such strategies (Jegadeesh and Titman, 2001; Grinblatt and Keloharju, 2000; Grinblatt, Titman, and Wermers, 1995; Solomon, Solges, and Sosyura, 2014). In particular, a series of articles have documented a strong positive relation between mutual fund past performance and subsequent fund inflows (see, e.g., Goetzmann and Massa, 2002; Sirri and Tufano, 1998). However, most of previous studies are based on fund level data with all individual traders aggregated. Individual momentum traders were not identified and their performances were not evaluated. Little is known whether individual traders could successfully implement momentum strategy to yield profit in real life. Here we ask whether there exist momentum traders in 401(k) plans and whether they could achieve portfolio performance improvements.

This question fits into the larger question of whether 401(k) traders can improve their 401(k) portfolios by implementing a trading strategy-a question of particular interest to policymakers and plan sponsors who oversee the plans, and to plan participants who will rely on their 401(k) accruals to finance their retirements. If 401(k) participants were able to successfully adopt a trading strategy, such as momentum trading, that would boost their 401(k) balance by the time of retirement, this would not only benefit the economic welfare of individual participants but would also increase soundness and stability of the entire retirement system. However, if momentum trading and other strategies used to improve 401(k) performance do not actually generate gains or even lead to losses, participants need to know this and refrain from adopting such strategies. Without information on how such strategies perform, individuals could end up siphoning off their retirement wealth with inappropriate behavior, while the plans themselves also experience management costs.

Unfortunately, compared with the extensive literature on momentum trading outside retirement accounts (e.g., Pettengill, Edwards, and Schmitt, 2006; Pettengill, Edeards, and Griggs, 2009), momentum traders in 401(k) plans have been largely overlooked. The literature contains little on whether 401(k) traders adopt momentum strategies and how these momentum traders perform. In fact, there are many reasons to suspect that investors may exhibit different behavior when trading with retirement and nonretirement accounts. Studies on mental accounting observe that investors tend to split their investment into a safe account, which is designed to maintain wealth level, and a risky account, used for speculation; their choices in separate accounts vary (Choi, Laibson, and Madrian, 2007; Rockenbach, 2004). A 401(k) account would be considered a safe account, meant for securing retirement wealth, whereas active nonretirement trading accounts would be considered risky accounts and meant for speculation. Because active trading accounts and 401(k) plans serve completely different functions, investors may exhibit different behavior when trading with retirement and nonretirement accounts. In fact, literature has shown that 401(k) participants engage in trading infrequently because of inertia, which is sharply different from the excessive trading in discount brokerage accounts (Agnew, Balduzzi, and Sunden, 2003; Tang, Mitchell, and Utkus, 2012); plan sponsors seem not to expect 401(k) plan participants to excel in profitable trading. …

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