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Presented by: Bhavin Gandhi Jaime Tibaduiza Althea Lim Sean Findley Slide 2 Does the Stock Market Overreact? ByWerner F. M. De Bondt; Richard Thaler Slide 3 Does the stock market overreact? Most people overreact to unexpected events CRSP monthly return data is consistent with that This is a violation of Bayes rule Definition of Bayes rule Example of Bayes rule Slide 4 Individual psychology and market behavior What is an overreaction? Kahneman and Tversky: Representativeness heuristic Observation by J. M. Keynes Theory of investment value by Williams Slide 5 Price to earnings (P/E) ratio anomaly Dividends do not vary significantly to justify stock price movement Correlation between stock prices and following years earnings Investors attach misappropriate importance to short- run Alternative explanation given by Basu: price-ratio hypothesis Slide 6 The overreaction hypothesis: Empirical Tests Test of semi-strong form of market starts at t = 0 Formation of portfolio on basis of some event affecting all portfolios (e.g.: earnings) Measurement of residual portfolio return at t>0 = 0 Results can be affected by CAPM, poor estimation of alpha and beta, weak-form inefficiency Slide 7 Test assessed in this study Systematic nonzero residual return after portfolio formation (t>0) Association with systematic residual returns in pre- formation (t