Abstract
AbstractSeveral studies have found mean reversion in monthly stock returns over long horizons. However, these studies can be challenged for several reasons, including the neglect or possible misspecification of risk premia. The current paper analyzes daily Dow returns over short horizons, which obviates the most serious issues in long-horizon studies using monthly data. There is strong evidence of overreaction in that large positive and (especially) negative returns tend to be followed by persistent, substantial, and statistically persuasive reversals over the next 10 days.
Highlights
Keynes (1936, p. 148) famously observed that “day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and nonsignificant character, tend to have an altogether excessive, and even absurd, influence on the [stock] market.” If true, such overreaction might be the basis for Warren Buffett’s (2008) memorable advice, “Be fearful when others are greedy, and be greedy when others are fearful.” If investors often overreact, causing excessive fluctuations in stock prices, it may be profitable to bet that large price movements will be followed by price reversals.There is a rich literature on long-horizon mean reversion in monthly stock returns, but several reasons for skepticism
When a stock was in the Dow, its adjusted daily return was calculated relative to the average return on the other 29 Dow stocks that day
There is considerable evidence, in a variety of contexts, that people overreact to recent events, overweighting the importance of new information relative to previous information
Summary
Keynes (1936, p. 148) famously observed that “day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and nonsignificant character, tend to have an altogether excessive, and even absurd, influence on the [stock] market.” If true, such overreaction might be the basis for Warren Buffett’s (2008) memorable advice, “Be fearful when others are greedy, and be greedy when others are fearful.” If investors often overreact, causing excessive fluctuations in stock prices, it may be profitable to bet that large price movements will be followed by price reversals.There is a rich literature on long-horizon mean reversion in monthly stock returns, but several reasons for skepticism. The regression fallacy is to see the abnormal financial results in 1920 (the new information) and conclude that a firm is as good or bad as the data indicate (the overreaction). They concluded that, The results indicate that information that causes stock prices to change is absorbed by the market in a single day.
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