Does the stock Market Overreact? TORIo Werner F M. De Bondt: Richard Thaler The Journal of Finance, Vol. 40, No 3, Papers and Proceedings of the Forty-Third Annual Meeting American Finance Association, Dallas, Texas, December 28-30, 1984 (Jul,1985),pp.793-805 Stable url http://links.jstor.org/sici?sici=0022-1082%28198507%02940%3a3903c793%03adtsmo%3e2.0.c0%3b2-q The Journal of Finance is currently published by American Finance Association Your use of the JSTOR archive indicates your acceptance of JSTOR'S Terms and Conditions of Use, available at http://wwwjstor.org/about/terms.htmlJstOr'sTermsandConditionsofuSeprovidesinpartthatunlessyou have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the jStoR archive only for your personal, non-commercial use Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://wwwjstor.org/journals/afina.html Each copy of any part of a jSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission JStOR is an independent not-for-profit organization dedicated to creating and preserving a digital archive of scholarly journals. For more information regarding JSTOR, please contact support @jstor. org http://www」]stor.org Thu Apr2711:16:422006
HE JOURNAL OF FINANCE· VOL. XL NO.3·JULY1985 Does the Stock Market Overreact? WERNER F M. De bondt and RICHARD THALER* ABSTRACT 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 portfolio formation 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 mpirical 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, a 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 evi- dence 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 byJ M. Keynes: .. day-to-day fluctuations in the profits of existing investments University of wisconsin at Madison and Cornell University, respectively. The financial support the C.I.m. Doctoral Fellowship Program(Brussels, Belgium)and the Cornell G Management is gratefully acknowledged. We received helpful comments from Seymour Smidt, Dale Morse, Peter Bernstein, Fischer Black, Robert Jarrow, Edwin Elton, and Ross Watts 793
The Journal of finance 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 T'versky"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 Shill [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 follow- ing 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 The price earnings ratio(P/E)anomaly refers to the observation that stocks with extremely low P/E ratios(i. e, lowest decile)earn larger risk-adjusted returns than high P/E stocks(Basu [31). Most financial economists seem to regard the anomaly as a statistical artifact. Explanations are usually based on alleged misspecification of the capital asset pricing model (CAPm). Ball [2] emphasizes the effects of omitted risk factors. The P/E ratio is presumed to be a proxy fo some omitted factor which, if included in the correct"equilibrium valuatic model, would eliminate the anomaly Of course, unless these omitted factors can be identified, the hypothesis is untestable. Reinganum [21] has claimed that the small firm effect subsumes the P/E effect and that both are related to the sam set of missing(and again unknown) factors. However, Basu[4] found a significant P/E effect after controlling for firm size, and earlier Graham [11] even found ar effect within the thirty dow Jones Industrials, hardly a group of small firms! An alternative behavioral explanation for the anomaly based on investor overreaction is what Basu called the "price-ratio"hypothesis (e.g, Dreman [8]) Companies with very low P/E's are thought to be temporarily "undervalued because investors become excessively pessimistic after a series of bad earnings reports or other bad news. Once future earnings turn out to be better than the unreasonably gloomy forecasts, the price adjusts. Similarly, the equity of com panies with very high P/E's is thought to be"overvalued, " before (predictably) While the overreaction hypothesis has considerable a priori appeal, the obt question to ask is: How does the anomaly survive the process of arbitrage? There Of course, the variability of stock prices may also reflect changes in real interest rates. If so, the ally observed. A third hypothesis, advocated by Marsh and Merton [19], is that gs are a result of his misspecification of the dividend process
is really a more general question here. What are the equilibria conditions for markets in which some agents are not rational in the sense that they fail to revise their expectations according to Bayes'rule? Russell and Thaler [24] address this issue. They conclude that the existence of some rational agents is not sufficient to guarantee a rational expectations equilibrium in an economy with some of what they call quasi-rational agents. ( The related question of market equilibria with agents having heterogeneous expectations is investigated by Jarrow [13].) While we are highly sensitive to these issues, we do not have the space to address them here Instead, we will concentrate on an empirical test of the overreaction hypothesis. If stock prices systematically overshoot, then their reversal should be predict able from past return data alone, with no use of any accounting data such as earnings. Specifically, two hypotheses are suggested: (1)Extreme movements in stock prices will be followed by subsequent price movements in the opposite direction.(2) The more extreme the initial price movement, the greater will be the subsequent adjustment. Both hypotheses imply a violation of weak-form market efficiency. To repeat, our goal is to test whether the overreaction hypothesis is predictive In other words, whether it does more for us than merely to explain, ex post, the P/E effect or Shiller's results on asset price dispersion. The overreaction effect deserves attention because it represents a behavioral principle that may apply in many other contexts. For example, investor overreaction possibly explains Shill er's earlier [26] findings that when long-term interest rates are high relative to short rates, they tend to move down later on. Ohlson and Penman [20 have further suggested that the increased volatility of security returns following stock splits may also be linked to overreaction. The present empirical tests are to our knowledge the first attempt to use a behavioral principle to predict a new market The remainder of the paper is organized as follows. The next section describes the actual empirical tests we have performed. Section II describes the results Consistent with the overreaction hypothesis, evidence of weak-form market inefficiency is found. We discuss the implications for other empirical work on asset pricing anomalies. The paper ends with a brief summary of conclusions I. The Overreaction Hypothesis: Empirical Tests The empirical testing procedures are a variant on a design originally proposed by beaver and Landsman [5]in a different context. Typically, tests of semistror form market efficiency start, at time t=0, with the formation of portfolios on the basis of some event that affects all stocks in the portfolio, say, an earnings announcement. One then goes on to investigate whether later on(t>0)the estimated residual portfolio return iptmeasured relative to the single-period CAPM--equals zero Statistically significant departures from zero are interpreted as evidence consistent with semistrong form market inefficiency, even though the results may also be due to misspecification of the CAPm, misestimation of the relevant alphas and or betas or simply market inefficiency of the weak form
In contrast, the tests in this study assess the extent onzero residual return behavior in the period after portfolio formation(t>0) is associated with systematic residual returns in the preformation months (t< 0). We will focus on stocks that have experienced either extreme capital gains or xtreme losses over periods up to five years. In other words, winner"(w)and loser"portfolios(L)are formed conditional upon past excess returns, rather than some firm-generated informational variable such as earnings. on Following Fama [9], the previous arguments can be formalized by writing the fficient market's condition E(Rit -Em(Rt FmiIFi-n=E(untI Ft-1)=0 where F-I represents the complete set of information at time t-1, Rit is the return on security j at t, and Em(Rit| Fr-1)is the expectation of Rit, assessed by the market on the basis of the information set Fm. The efficient market hypothesis implies that e(uwt Ft-1)= E(uu I Ft-1)=0. As explained in the introduction, the overreaction hypothesis, on the other hand, suggests that In order to estimate the relevant residuals, an equilibrium model must be specified. a common procedure is to estimate the parameters of the market model (see e. g, Beaver and Landsman [5). what will happen if the equilibrium model is misspecified? As long as the variation in Em(Rt I Fr-1)is small relative to the movements in uit, the exact specification of the equilibrium model makes little difference to tests of the efficient market hypothesis. For, even if we knew the correct"model of Em(Rit I F1), it would explain only small part of the variation in rit. Since this study investigates the return behavior of specific portfolios over extended periods of time (indeed, as long as a decade), it cannot be merely assumed that model misspecification leaves the conclusions about market effi iency unchanged. Therefore, the empirical analysis is based on three types of return residuals: market-adjusted excess returns; market model residuals; and excess returns that are measured relative to the Sharpe-Lintner version of the CAPM. However, since all three methods are single- index models that follor from the CAPM, misspecification problems may still confound the results De bondt [7 formally derives the econometric biases in the estimated market djusted and market model residuals if the true?"model is multifactor, e.g A,+B Rmt+CiX,+ejt. As a final precaution, he also characterizes the securities in the extreme portfolios in terms of a number of financial variables If there were a persistent tendency for the portfolios to differ on dimensions that may proxy for "risk, then, again, we cannot be sure whether the empirical results It turns out that, whichever of the three types of residuals are used, the results 2 Presumably this same reasoning underlies the c f measuring abnormal security E(R,)equals (where, by assump 1 for all]), rather than more complicated market mo iduals, let along residuals relative to some