Investors, being human, are not always perfectly rational, but sometimes make decisions that are influenced by their emotions or cognitive biases, which can effect market prices in interesting and predictable ways. Such is the one sentence summary and motivating principle behind behavioral finance, a topic I’ve written about quite a bit here myself. But how much of what we know about the behavior of investors is influenced by the cultures which they come from? This is the question posed by researchers in a fascinating paper I recently came across called Individualism and Momentum Around the World.

In the paper, the authors investigate how cultural variation is related to the profitability of one of the most famous and historically successful market “anomalies”: the momentum effect. Momentum is the tendency of recently outperforming stocks (or other assets) to continue to outperform, and likewise for underperforming stocks. The effect has been observed in markets around the world and in data series going back over two hundred years, making it one of the most robust findings in empirical finance. But because momentum profits seem to be unrelated to standard measures of risk, the effect is usually ascribed to “irrational” causes like investor overconfidence, inattention, or herd mentality. The authors look at how these effects may be mediated by culture, looking in particular at measures of individualism vs collectivism in society. They hypothesize that individualistic cultures are associated with more overconfident investors, who overestimate their investment knowledge and trade more aggressively on their beliefs, leading to the predictable price trends of momentum.

This is interesting because I could see it going the other way as well. It could be that in collectivist cultures investors all mimic one another’s decisions and that’s what gives rise to the momentum effect. With no obvious reason to be confident it should go one way or another, we’re left with the data to sort it out. The authors compare the returns on a long-short momentum strategy and other market data within the markets of a sample of 50 countries against each country’s score on Hofstede’s Individualism vs. Collectivism index, a widely cited scale developed by social psychologists based on extensive survey data. According to the authors, “In individualistic cultures, individuals tend to view themselves as ‘an autonomous, independent person’… while in collectivistic cultures, individuals view themselves ‘not as separate from the social context but as more connected and less differentiated from others.'” Western cultures, especially the Anglophone countries, are famously the most individualistic in the world, while Eastern cultures are known to be more relatively collectivist, though there is considerable variation within these groupings. The authors cite previous work in psychology demonstrating that persons from individualistic cultures are more likely to evaluate their own abilities as being above average, and speculate that this is likely to lead to more overconfident and excessive trading behavior when interacting with financial markets.

Their data support the hypothesis: the stock markets of more individualistic countries have higher trading volume, are more volatile, and provide greater momentum profits. And the effect size is substantial: in their sample several of the English-speaking countries experienced double-digit annual momentum returns while those of Japan, Korea, and Taiwan were not even statistically significant. Indeed, the authors cite the Japanese case as their motivating example behind the study, as Japan is somewhat famous in the literature as being the exception to the rule that momentum works “everywhere.”

I decided to replicate the authors’ findings myself by downloading Hofstede’s data and comparing it to factor returns data provided by AQR (the UMD factor). Below I plot the relation between the individualism score and the average annualized returns to a long-short momentum strategy between 1987 and 2016 for a sample of 20 developed market countries.

Interesting… So if you’re reading this post in your native language, you may want to reconsider when deciding to buck the trend with your investments (unless you’re Hong Kongese or Singaporean, then you’re probably fine).

The intersection of culture and investor behavior is rich and underexplored vein of research, and one I will probably be returning to in future posts. Stay tuned!

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