Past Returns and the Perceived Sharpe Ratio

We find that human perception contradicts the market efficiency assertions that high return is accompanied by high risk and that past returns do not affect future prices. A survey of investors reveals that the last week realized returns are positively correlated with perceived returns and negatively correlated with perceived risk. Thus, in the human mind there is a free lunch opportunity, where the perceived Sharpe ratio is positively correlated with short-term past returns. As higher perceived Sharpe ratios are also followed by more actual stock buying, our study provides a novel explanation to the observed short-term autocorrelations in stock returns