What happens when important news hits the financial markets? Suppose a company reports earnings much higher than expected or announces a big acquisition. Traders and investors rush to digest the information and push stock prices to a level they think is consistent with what they have heard. But do they get it right? Do they react properly to the news they receive? Recent evidence suggests investors make systematic errors in processing new information that may be profitably exploited by others.
In a 1997 paper, “A Model of Investor Sentiment,” University of Chicago Graduate School of Business assistant professor of finance Nicholas Barberis and finance professor Robert W. Vishny, along with former Chicago faculty member Andrei Shleifer of Harvard University, argue that there is evidence that in some cases investors react too little to news, and that in other cases, they react too much.
The authors then propose a model, based on ideas from psychology, of how investors make mistakes when they process new information.
The evidence the authors discuss presents a challenge to the efficient markets theory -- the theory that information is immediately and accurately reflected in a share's price -- and suggests that in a variety of markets, sophisticated investors can earn superior returns by taking advantage of underreaction and overreaction without bearing extra risk.
In an important paper published in 1985, Werner De Bondt of the University of Wisconsin and Richard Thaler of the University of Chicago Graduate School of Business discovered what they claimed was evidence that investors overreact to news. Analyzing data dating back to 1933, De Bondt and Thaler found that stocks with extremely poor returns over the previous 5 years subsequently dramatically outperform stocks with extremely high previous returns, even after making the standard risk adjustments. Later work corroborated these findings.
“In other words,” says Barberis, “if an investor ranks thousands of stocks based on how well they did over the past three to five years, he or she can then make a category for the biggest `losers,' the stocks that performed badly, and another for the biggest `winners.' What you will find is that the group of the biggest losers will actually do very well on average over the next few years. So it is a good strategy to buy these previous losers or undervalued stocks.”
How might investor overreaction explain these findings?
Suppose that a company announces good news over a period of three to five years, such as earnings reports that are consistently above expectations. It is possible that investors overreact to such news and become excessively optimistic about the company's prospects, pushing its stock price to unnaturally high levels. In the subsequent years, however, investors realize they were unduly optimistic about the business and the stock price will correct itself downwards.
In a similar way, loser stocks may simply be stocks that investors have become excessively pessimistic about. As the misperception is corrected, these stocks earn high returns.
The authors believe that investors sometimes also make the mistake of underreacting to certain types of financial news.
Suppose a company announces quarterly earnings that are substantially higher than expected. The evidence suggests that investors see this as good news and send the stock price higher, but for some reason, not high enough. Over the next six months, this mistake is gradually corrected as the stock price slowly drifts upwards towards the level it should have attained at the time of the announcement. Investors who buy the stock immediately after the announcement will benefit from this upward drift and enjoy higher returns.
The same underreaction principle applies to bad news. If bad news is announced -- like if a company announces it is cutting its dividend -- then the stock price will fall. However, it does not fall enough at the time of the announcement and instead continues to drift downwards for several months.
In both cases, when investors are faced with either good or bad announcements, they initially underreact to this news and only gradually incorporate its full import into the stock price. This signals an inefficient market.
So what strategy should smart investors adopt? In the long run, it is better to invest in value stocks, stocks with low valuations (overreaction theory); but in the short run, the best predictor of returns in the next 6 months is returns over the last 6 months (underreaction theory).
“In the short run, you want to buy relative strength,” explains Vishny. “This might seem contradictory, but we can explain how both of those facts might be true using some basic psychology and building that into a model for how people form their expectations for future earnings.”
In the new field of behavioral finance, researchers seek to understand whether aspects of human behavior and psychology might influence the way prices are set in financial markets.
“Our idea is that these market anomalies -- underreaction and overreaction -- are the results of investors' mistakes,” says Vishny. “In this paper, we present a model of investor sentiment -- that is, of how investors form beliefs -- that is consistent with the empirical findings.”
In explaining investor behavior, the authors' model is consistent with two important psychological theories: the “representative heuristic” and “conservatism.”
The representative heuristic refers to the fact that people tend to see patterns in random sequences. Certainly it would be to an investor's advantage to see patterns in financial data, if they were really there. Unfortunately, investors are often too quick to see patterns that aren't genuine features of the data.
In reality, long-run changes in company earnings follow a fairly random pattern. However, when people see a company's earnings go up several years in a row, they believe they have spotted a trend and think that it is going to continue. Such excessive optimism pushes prices too high and produces effects which support the authors' theory of overreaction.
There are also well-known biases in human information processing that would predict underreaction to new pieces of information. One such bias, conservatism, states that once individuals have formed an impression, they are slow to change that impression in the face of new evidence. This corresponds directly to underreaction to news. Investors remain skeptical about new information and only gradually update their views.
A Matter of Efficiency
The authors note that while such links between psychology and finance sound plausible to many, a substantial proportion of the academic finance community views them with considerable skepticism.
“The preceding evidence is puzzling for those who believe the stock market is efficient,” says Barberis, “because it appears to suggest quite profitable investment strategies that verge on being `free lunches' even after taking transaction costs into account.”
Efficient markets theorists would explain that investing in the loser (value) stocks produces higher returns simply because there is more risk in the investment for which investors must be compensated.
“We are taking the alternative approach, saying that perhaps there isn't any increased risk, and the underreaction and overreaction phenomena can be explained by genuine mistakes that people are making,” says Barberis. “We look to the psychology literature to explain these mistakes and illustrate how they generate the findings in the data.”
While researchers in behavioral finance continue to develop advanced models of the interplay of psychology and finance, proponents of efficient markets will continue to probe the relationships between risk and return. The debate is far from over.
Nicholas Barberis is an assistant professor of finance at the University of Chicago Graduate School of Business. Robert W. Vishny is the Eric J. Gleacher Distinguished Service Professor of Finance at the school.