The Efficient Market Hypothesis has been regarded as a model so far, when the hypothesis was stated by Fama (1970). The theory states the rational behavior was proceed by the rational investors in the securities market and the investors’ decision was built on the expected theory, risk aversion and maximize the utility function. Since 1980s, plenty of empirical studies indicate that the investors’ behavior do not match the traditional theory in the real situation, in addition, most investors whose behavior is not rational at all, for example, investors usually make decisions with overconfidence, overoptimistic and cognitive bias which generate the result is not the optimal decision-making in the true life.

Many anomalies which could not explained by the traditional theory; therefore, the behavior finance theory was developed based on the psychology and attempt to explain these anomalies; Kahneman and Tverskey (1979) state that investors are unable to make decision with adequate and available information rather than like the individual was described in the EMH who will do complete analysis to all situations. They think most people has cognitive bias and makes decision based on the rule of thumb. In fact, investors’ decisions will depend on their psychological factors, the environment or the error news so that the market is not perfect as the efficient market; it implies that there are arbitrage chances in the market. Two investment-related anomalies are momentum and contrarian strategy.

Momentum strategy states that the stock will continue to rise or continue to decline in the short term so that buying the past winner and selling the past loser; contrarian strategy is contrary, which means the price will adjust reverse so that buying the past loser and selling the past winner. The views of the two strategies are the former means the existence of the underreaction, the latter means the existence of the overreaction.

Since Jegadeesh and Titman (1993) state the momentum strategy and the De Bondt and Thaler (1985) state the contrarian strategy, many researchers who began to study the source of the abnormal return in order to examine whether if the profitability exist or not. Such as Chan (1988) states the time-varying risk, Zarowin (1989) points out the seasonal effect, Moskowitz and Grinblatt (1999) address the industrial momentum and Conrad and Kual (1998) propose the time series predictability or cross-sectional variation in the mean returns. By the past researches, we can find that the market anomalies who are often accompanied by the psychological factors of the investors and the accuracy of the interpretation of information which leads the market price to overreaction and underreaction.

In Taiwan, the major investment tool is stock; as the table 1-1 displays that the percentage of the domestic individuals is much higher, there were at least 60% over the past 10 years, in addition, Chen et al (2006) point out that Taiwan stock market is not weak-efficient market. Therefore, there are characteristics of shorter holding period and higher turnover which leads that the fluctuation is larger in Taiwan; however, the De Bondt and Thalet (1985) find out the past loser would have higher return than the past winner when holding them for 3-5 years. Furthermore, Jegadeesh and Titman (1993) state that implement the momentum strategy could 1% excess return. According to these evidence, momentum and contrarian strategy were supported in USA. The features of Taiwan stock market are unlike the USA stock market so that it is worthy to study that whether if the momentum strategy or contrarian strategy is suitable to implement in Taiwan.

Table 1-1: the Proportion of Types of Investors in Taiwan Stock Market

Objective

The study collects daily data to examine the stock market whether if the momentum effect exists based on the momentum strategy. It also tests whether if getting the excess return when holding different period based on the prior return, or implementing the contrarian strategy will be better than using momentum strategy.

Literature Review

In the traditional financial theory, the Capital Asset Pricing Model, CAPM and the Efficient Market Hypothesis, EMH are cornerstones which had dominated the modern financial field for decades. In recent years, there are plenty of empirical evidences indicate that lots of anomaly against the traditional financial theory. The study will use momentum strategy to examine whether if gain the significant return in Taiwan stock market.

The profit of the momentum strategy is equal the loss of the contrarian strategy; on the contrast, the loss of the momentum strategy is equal the profit of the contrarian strategy. In other words, investors could get the significant profit by implementing the momentum strategy; they would get loss by exploiting the contrarian strategy or vice versa; therefore, the study including the related review about the contrarian strategy.

Traditional Financial Theory

Efficiency Market Hypothesis (EMH)

EMH states that the share price will fully reflect in all the related information correctly and immediately. According to the hypothesis, no investment strategy can earn excess return, in other words, no one can bet the market by any trading strategy as the market is equilibrium. In the traditional finance, the model was assumed with the agents are rational which means that the agents could renew their concept accurately and make right decision. Shleifer(2000) point out that the EMH was established on three assumption. First, all investors are assumed to be rational and hence they are able to assess the securities. As the investors who obtain new information about the securities they bought, they will correctly and quickly respond to the news by rising up the price as it’s a good news or bringing price down as it’s a bad news. Hence, as the assumption, all asset prices should adjust to the information immediately. Even though most of all investors are not rational, their trading is random and it could balance the price effect. The influence on price will cancel each other out as investors have wrong decision making in the market. Despite most people with homogeneous irrational behavioral, the price would return to be rational by exploiting arbitrage mechanism. For example, buy the underpriced asset on a market and sell the identical or similar asset on the other market which leads the price back to balance. However, some market phenomena corroborate performances which could not be explained by the hypothesis.

Capital Asset Pricing Model (CAPM)

CAPM was developed by Sharpe et al (1960).It illustrate that the relationship between the required return of securities and the systemic risk, as an equilibrium. In addition, the purpose of the model is assist investors to decide the price of the asset. Its assumptions are much tough than EMH, it assumes that all the investors who can get the same information in the same time and only concern the trade-off of risk and return as they chose investment targets. Furthermore, there is no transaction cost, no tax and no limitation on security trading in the perfect market.

Behavioral Finance

Barberis N., & Thaler R. (2002) point out that behavioral finance is a new and a better approach to interpret that not all agents are rational at all. The new method involves two components which are limits to arbitrage and psychology.

Limit to Arbitrage

Shleifer, A. and Vishny, R. (1997) point out that the market is inefficient and the traders are irrational and the interaction between the rational and irrational, the irrational trading will bring enormous and long standing impact on price. If rational traders who want to play the power of arbitrage, they have to be provided with some essential conditions. First, the irrational traders could not be too much, or they will dominate the market. Second, the market must to permit the low cost shorting which only for rational traders, otherwise, irrational traders who make the price deviation by short selling. Finally, the true value of assets should be come to light, or these irrational traders would not adjust their behavior until they realize that their evaluation of the stock price is error. Apparently, these conditions above mentioned are difficult to satisfy, therefore, Shleifer, A. and Vishny, R. (1997) call it ‘Limit to Arbitrage.’

Psychology

Behavioral financial scholars think that irrational investors’ decision would be affected by their own beliefs and preferences. Some reasons caused the irrationality were summarized as follow. First, investors would make decision by following their beliefs. Sometimes, they are too over optimism to ignore whether the fact is or not. Overconfidence is one of concepts which were explained various phenomena, empirical studies have shown that investors often over-believe the accuracy of their judgement. Sudak and Suslova states that people has insufficient knowledge of the confidence level so that they mistake as predicting. As a result of information insufficiency which leading to the overconfidence and investors do wrong decisions. Consequently, it not only causes investors who take too much money on transaction costs,