Investors’ Misreaction to Unexpected Earnings: Evidence of Simultaneous Overreaction and Underreaction

Michael Kaestner

No 2005-3, Accepted Papers Series from Montpellier University, Center for Research in Finance

Abstract: Behavioral Finance aims to explain empirical anomalies by introducing investor psychology as a determinant of asset pricing. Two kinds of anomalies, namely underreaction and overreaction, have been established by an impressive record of empirical work. While underreaction defines a slow adjustment of prices to corporate events or announcements, overreaction deals with extreme stock price reactions to previous information or past performance. Theoretical models have shown that both phenomena find potential explanations in cognitive biases, that is, investor irrationality. This study investigates current and past earnings surprises and subsequent market reaction for listed US companies over the period 1983-1999. The results suggest that investors simultaneously exhibit short-term underreaction to earnings announcements and long-term overreaction to past highly unexpected earnings. A potential explanation for the reported overreaction phenomenon is the representativeness bias. As I show, the overreaction and the later reversal is stronger for events, which exhibit a long series of similar past earnings surprises.

Keywords: Behavioral finance; overreaction; underreaction; pead; representativeness bias; earnings announcements (search for similar items in EconPapers)
JEL-codes: D84 G14 (search for similar items in EconPapers)
Date: 2005-12-07
New Economics Papers: this item is included in nep-fin and nep-fmk
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Persistent link: https://EconPapers.repec.org/RePEc:grf:mtpaps:mk003

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