Testing Behavioral Finance Theories Using Trends and Sequences in Financial Performance

Wesley Chan, Richard Frankel and S.P. Kothari

No 4375-02, Working papers from Massachusetts Institute of Technology (MIT), Sloan School of Management

Abstract: Models based on psychological biases can explain momentum and reversal in stock returns, but risk overfitting of theory to data. We examine a central psychological bias, representativeness, which underlies many behavioral-finance theories. According to this bias, individuals form predictions about future outcomes based on how closely past outcomes fit certain categories. To produce out-of sample tests, we use accounting performance to identify these categories and test the idea that investors misclassify firms and thus make biased forecasts. We find evidence of short-term accounting momentum, consistent with the idea that investors fail to immediately incorporate new information, but find no support for long-term reversal related to accounting performance. Contrary to theory, we find little evidence that the consistency of past accounting performance is related to future returns

Keywords: Behavioral Finance; Behavioral-finance (search for similar items in EconPapers)
Date: 2002-10-23
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Citations: View citations in EconPapers (3)

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