Do Stock Market Investors Overreact?

Abstract

This paper investigates the evidence on the stock market overreaction hypothesis (ORH), which holds that, if stock prices systematically overshoot as a consequence of excessive investor optimism or pessimism, price reversals should be predictable from past price performance. The ORH stands in contradiction to the efficient markets hypothesis which is a cornerstone of financial economics. This study is unique in the overreaction literature because it is restricted to larger and better‐known listed companies, whose shares are more frequently traded. This restriction more or less eliminates two alternative explanations to the overreaction hypothesis: it minimises the influence of bid‐ask biases and infrequent trading, and reduces the possibility that reversals are primarily a small‐firm phenomenon. The paper also investigates a third alternative explanation, namely that time‐varying risk explains the reversal effect. The study employs unbiased methods of return computation and uses data from 1975 to 1991 for nearly 1,000 UK companies. Overall, the evidence appears to be consistent with the overreaction hypothesis, subject to certain qualifications.