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38 - Do Analysts Overreact?

from PART THREE - REAL-WORLD APPLICATIONS

Published online by Cambridge University Press:  05 June 2012

Werner F. M. De Bondt
Affiliation:
Department of Finance, Investment & Banking University of Wisconsin – Madison
Richard H. Thaler
Affiliation:
Graduate School of Business University of Chicago
Thomas Gilovich
Affiliation:
Cornell University, New York
Dale Griffin
Affiliation:
Stanford University, California
Daniel Kahneman
Affiliation:
Princeton University, New Jersey
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Summary

It has long been part of the conventional wisdom on Wall Street that financial markets overreact. Both casual observation and academic research support irrational exuberance (Shiller, 2000). For instance, Shiller's survey evidence relating to the 1987 stock market crash reveals that investors were reacting to each other's behavior rather than to hard economic news.

In prior research, we argued that mean reversion in stock prices is evidence of overreaction. In our 1985 paper, we showed that stocks that were extreme losers over an initial 3to 5-year period earned excess returns over subsequent years. In the 1987 paper, we showed that these excess returns could not easily be attributed to changes in risk, tax effects, or the small firm anomaly. Rather, we argued that the excess returns to losers might be explained by biased expectations of future earnings. We found that the earnings for losing firms had fallen precipitously while their share prices were lagging market performance, but then rebounded strongly over the next few years. Perhaps, we speculated, “the market” did not correctly anticipate this reversal in earnings. This hypothesis, of excessive pessimism about the future prospects of companies that had done poorly, was suggested by the work of Kahneman and Tversky (1973). They found that people's intuitive forecasts have a tendency to overweight salient information such as recent news, and underweight less salient data such as long-term averages.

Type
Chapter
Information
Heuristics and Biases
The Psychology of Intuitive Judgment
, pp. 678 - 685
Publisher: Cambridge University Press
Print publication year: 2002

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