Testing Behavioral Finance Theories Using Trends and Sequences in Financial Performance

Abstract

Assessing the predictive ability of behavioral finance theories using out-of-sample data is important. Without predictive tests, the risk of overfitting theory to data is large considering the potentially boundless set of psychological biases underlying the behavioral explanations for observed security price behavior. We test pricing effects attributed to a central psychological bias, representativeness, which underlies many behavioral-finance theories. This bias influences individuals beliefs about future outcomes based on how closely past outcomes represent 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 systematically misprice them. Evidence fails to suggest that trends and sequences of accounting performance, as a proxy for representativeness bias, influence investor expectations to generate return predictability.