Price Underreaction Research Articles

Prospect Theory, Mental Accounting, and Momentum

The tendency of some investors to hold on to their losing stocks, driven by prospect theory and mental accounting, creates a spread between a stock's fundamental value and its equilibrium price, as well as price underreaction to information. Spread convergence, arising from the random evolution of fundamental values and updating of reference prices, generates predictable equilibrium prices that will be interpreted as possessing momentum. Cross-sectional empirical tests are consistent with the model. A variable proxying for aggregate unrealized capital gains appears to be the key variable that generates the profitability of a momentum strategy. Past returns have no predictability for the cross-section of returns once this variable is controlled for.

Tests of Analysts' Overreaction/Underreaction to Earnings Information as an Explanation for Anomalous Stock Price Behavior

ABSTRACTThis study examines whether security analysts underreact or overreact to prior earnings information, and whether any such behavior could explain previously documented anomalous stock price movements. We present evidence that analysts' forecasts underreact to recent earnings. This feature of the forecasts is consistent with certain properties of the naive seasonal random walk forecast that Bernard and Thomas (1990) hypothesize underlie the well‐known anomalous post‐earnings‐announcement drift. However, the underreactions in analysts' forecasts are at most only about half as large as necessary to explain the magnitude of the drift. We also document that the “extreme” analysts' forecasts studied by DeBondt and Thaler (1990) cannot be viewed as overreactions to earnings, and are not clearly linked to the stock price overreactions discussed in DeBondt and Thaler (1985, 1987) and Chopra, Lakonishok, and Ritter (Forthcoming). We conclude that security analysts' behavior is at best only a partial explanation for stock price underreaction to earnings, and may be unrelated to stock price overreactions.