Investors are often concerned about the lead-lag effect of the stock market because it can have a substantial impact on their ability to realize growth in the value of their portfolio -- especially in the short-term. The lead-lag effect varies depending on the industry, and is thought to be connected market information diffusion. Understanding the concepts of information diffusion and the lead-lag effect helps investors manage their stock portfolio risk.
The lead-lag effect is an observed phenomena of the financial markets where stock returns on some businesses -- usually larger firms -- are realized ahead of stock returns on other businesses. This has an important impact on an investment portfolio for two reasons. Leading stocks provide predictability of results for lagging stocks, which can suggest buying or selling opportunities. Additionally, a portfolio comprised primarily of industry leaders is likely to experience more immediate results in response to financial news events, while a portfolio made up of lagging securities will realize the effects of news more slowly.
Information diffusion is another issue for investors in stock markets, and is related to the lead-lag effect. Information diffusion basically refers to the process of distributing new information to investors who have not yet received it. Information diffusion takes time, which means that some investors inevitably receive and act on information before others. This holds true for analysts and financial planners as well. Information diffusion slows down investors' and portfolio managers' reaction times to financial news, and as a result slows down corrections or enhancements to stock returns that might otherwise occur more quickly.
Research conducted at Ohio State University suggests a relationship between the lead-lag effect in stock returns and the diffusion of industry information. According to financial industry researcher Kewei Hou, the lead-lag effect generally occurs within an individual industry, with larger firms leading smaller firms. In addition, the effect appears to be the result of slow diffusion of information, especially in relation to news events. In addition firms that are considered value firms -- those with a consistent ability to deliver returns over the long-run -- tend to lead growth firms, which have less consistent returns but the potential for longer term growth.
Even though the lead-lag effect seems to have a relationship with the speed of industry information diffusion, this correlation is not necessarily universal to every industry, or at every time. Smaller and more volatile sectors tend to have a less obvious lead-lag effect than larger or more stable industries. In addition, the lead-lag effect may be more pronounced when there are breaks in trading activity and fewer investors are following and participating in the markets.
- University of California: Do Industries Lead Stock Markets?
- Ohio State University: Industry Information Diffusion and the Lead-Lag Effect in Stock Returns
- Journal of Finance: Market Segmentation and the Cross-Predictability of Returns
- New England Economic Review; Are Stock Returns Different over Weekends? A Jump Diffusion Analysis of the “Weekend Effect”; Peter Fortune
- Princeton University: When Are Contrarian Profits Due to Stock Market Overreaction?
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