Abstract
This study explores the effect of the gambler's fallacy on stock returns. I hypothesize that if during a number of consecutive trading days, a stock's return is positive (negative), then due to the gambler's fallacy, at least some of the investors may believe that the stock's price "has" to subsequently fall (rise), and thus, to increase their willingness to sell (buy) the stock, resulting in negative (positive) abnormal market-adjusted stock returns. Employing a large sample of daily stock price data, I was able to document that following relatively long sequences of positive (negative) stock returns, abnormal stock returns are on average significantly negative (positive), indicating the existence of the price pressure towards the return sign reversal. Moreover, the magnitude of the effect is stronger for longer return sequences. The effect is found to be more pronounced for smaller and more volatile stocks, and is robust to other relevant company - and stock-specific factors.
Highlights
Stock prices and returns have traditionally attracted enormous attention of both stock market researchers and practitioners
Since the effect of preceding return sequences on stock returns probably appears during the trading day when the stock return changes its sign, I append the zeroreturn days to the sequences
It should be emphasized that when defining the sequences of days with the same-sign returns, I consider the raw daily stock returns, which are those that may potentially create a ground for the investors' beliefs in further price reversals
Summary
Stock prices and returns have traditionally attracted enormous attention of both stock market researchers and practitioners. That is, its probability becomes higher than that of a black one In this respect, I expect that if during a number of consecutive trading days, a stock's return is positive (negative), because of the gambler's fallacy, at least some of the investors may believe that the stock's price "has" to subsequently fall (rise). I suggest that, to a casino where people tend to place more bets on a red number following longer sequences of black numbers appearing on the wheel, in the stock market, the longer the sequence of trading days with the samesign return for the respective stock, the stronger may be the investors' inclination to expect the reversal in the sign of the stock's return, leading to the price pressure in the direction of the reversal.
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