Does The Stock Market Overreaction Affects Stock Prices? via CSInvesting

Werner F. M. De Bondt And Richard Thaler*

July 1985


Research in experimental psychology suggests that, in violation of Bayes’ rule, most people tend to “overreact” to unexpected and dramatic news events. This study of market efficiency investigates whether such behavior affects stock prices. The empirical evidence, based on CRSP monthly return data, is consistent with the overreaction hypothesis. Substantial weak form market inefficiencies are discovered. The results also shed new light on the January returns earned by prior “winners” and “losers.” Portfolios of losers experience exceptionally large January returns as late as five years after portfolio formation.

Does The Stock Market Overreact? – Introduction

As ECONOMISTS INTERESTED IN both market behavior and the psychology of individual decision making, we have been struck by the similarity of two sets of empirical findings. Both classes of behavior can be characterized as displaying overreaction. This study was undertaken to investigate the possibility that these phenomena are related by more than just appearance. We begin by describing briefly the individual and market behavior that piqued our interest.

The term overreaction carries with it an implicit comparison to some degree of reaction that is considered to be appropriate. What is an appropriate reaction? One class,,of tasks which have a well-established norm are probability revision problems for which Bayes’ rule prescribes the correct reaction to new information.

It has now been well-established that Bayes’ rule is not an apt characterization of how individuals actually respond to new data (Kahneman et al. [14]). In revising their beliefs, individuals tend to overweight recent information and underweight prior (or base rate) data. People seem to make predictions according to a simple matching rule: “The predicted value is selected so that the standing of the case in the distribution of outcomes matches its standing in the distribution of impressions” (Kahneman and Tversky [14, p. 416]). This rule-of-thumb, an instance of what Kahneman and Tversky call the representativeness heuristic, violates the basic statistical principal that the extremeness of predictions must be moderated by considerations of predictability. Grether [12] has replicated this finding under incentive compatible conditions. There is also considerable evidence that the actual expectations of professional security analysts and economic forecasters display the same overreaction bias (for a review, see De Bondt [7]).

One of the earliest observations about overreaction in markets was made by J. M. Keynes:”… day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and nonsignificant character, tend to have an altogether excessive, and even an absurd, influence on the market” [17, pp. 153-154]. About the same time, Williams noted in this Theory of Investment Value that “prices have been based too much on current earning power and too little on long-term dividend paying power” [28, p. 19]. More recently, Arrow has concluded that the work of Kahneman and Tversky “typifies very precisely the exessive reaction to current information which seems to characterize all the securities and futures markets” [1, p. 5]. Two specific examples of the research to which Arrow was referring are the excess volatility of security prices and the so-called price earnings ratio anomaly.

The excess volatility issue has been investigated most thoroughly by Shiller [27]. Shiller interprets the Miller-Modigliani view of stock prices as a constraint on the likelihood function of a price-dividend sample. Shiller concludes that, at least over the last century, dividends simply do not vary enough to rationally justify observed aggregate price movements. Combining the results with Kleidon’s [18] findings that stock price movements are strongly correlated with the following year’s earnings changes suggests a clear pattern of overreaction. In spite of the observed trendiness of dividends, investors seem to attach disproportionate importance to short-run economic developments.

Stock Prices

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