Overreaction and Underreaction

"Recent empirical research in finance has uncovered two families of pervasive regularities: underreaction of stock prices to news such as earnings announcements, and overreaction of stock prices to a series of good or bad news. In this paper, we present a parsimonious model of investor sentiment, or of how investors form beliefs, which is consistent with the empirical findings. The model is based on psychological evidence and produces both underreaction and overreaction for a wide range of parameter values."
Barberis, Andrei Shleifer and Vishny (1998)

"Empirical research has uncovered two families of pervasive regularities: underreaction and overreaction of stock prices subject to series of good or bad news. The authors use a model of investors sentiment, which is consistent with the empirical findings, to explain such tendencies." Barberis, Shleifer and Vishny

"Barberis et al. (J. Financial Econ. 49 (1998) 307), construct a model in which investors use the prevalence of past trend reversals as an indicator of the likelihood of future reversals. While such "regime-shifting" beliefs are consistent with a variety of psychological theories, other contrary predictions are consistent with the same theories. We report two experiments with MBA-student participants that strongly support the existence of regime-shifting beliefs. We conclude that regime-shifting models can provide a useful framework for understanding market anomalies, including underreactions to earnings changes and overreactions to longterm earnings trends."
Bloomfield and Hales (2002)

"This paper presents a model in which a representative investor has only a noisy signal of the reliability of his information. This noise causes prices to underreact to reliable information and overreact to unreliable information. We call this phenomenon 'moderated confidence', because in both cases, the investor's confidence is moderated toward his prior expectation of reliability. Although moderated con"dence can be consistent with rationality, we construct a laboratory setting in which it is not. Still, we find strong support for both types of price errors. We also find that tests of weak-form efficiency can indicate overreactions, even when tests of semi-strong-form effciency indicate underreactions using exactly the same data. These results can help empirical researchers develop specific alternative hypotheses to market e$ciency, by helping them predict ex ante whether a given research study is likely to reveal over- or underreactions."
Bloomfield, Libby and Nelson

"A common explanation for departures from the EMH is that investors do not always react in proper proportion to new information. For example, in some cases investors may overreact to performance, selling stocks that have experienced recent losses or buying stocks that have enjoyed recent gains. Such overreaction tends to push prices beyond their 'fair' or 'rational' market value, only to have rational investors take the other side of the trades and bring prices back in line eventually. Another implication is that contrarian investment strategies — strategies in which 'losers' are purchased and 'winners' are sold — will earn superior returns."
Lo (1999)

"One of the accusations levelled at behavioural finance is that it predicts over-reaction, and at other times it predicts under-reaction. Fama (1998) claims that under-reaction and over-reaction cancel each other out."
Montier (2002)

"What we seem to have is overreaction at very short horizons, say less than one month (Lehmann, 1990), momentum possibly due to underreaction for horizons between three and twelve months (Jegadeesh and Titman 1993) and overreaction for periods longer than one year (De Bondt and Thaler 1985, 1987, 1990)."
Shefrin (2000)

Motivated by a variety of psychological evidence, Barberis, Shleifer and Vishny (1998) present a model of investor sentiment that displays underreaction of stock prices to news such as earnings announcements and overreaction of stock prices to a series of good or bad news. DanielHirshleiferSubrahmanyam98 propose a theory of security markets based on investor overconfidence (about the precision of private information) and biased self-attribution (which causes changes in investors' confidence as a function of their investment outcomes) which leads to market under- and overreactions. Hong and Stein (1999) model a market populated by two groups of boundedly rational agents: “newswatchers” and “momentum traders” which leads to underreaction at short horizons and overreaction at long horizons. Veronesi (1999) presented a dynamic, rational expectations equilibrium model of asset prices in which, among other features, prices overreact to bad news in good times and underreact to good news in bad times. LeeSwaminathan00 showed that past trading volume provides an important link between “momentum” and “value” strategies and these findings help to reconcile intermediate-horizon “underreaction” and long-horizon “overreaction” effects.

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