Does the Stock Market Overreact?

TLDR

Experimental psychology indicates that people tend to overreact to unexpected news, violating Bayes' rule. This study investigates whether such overreactions affect stock prices. CRSP monthly return data confirm the overreaction hypothesis, uncover weak‑form market inefficiencies, and reveal that loser portfolios earn exceptionally high January returns for up to five years.

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 of losers experience exceptionally large January returns as late as five years after portfolio formation.