Does the UK Stock Market Overreact? Some Further Evidence for Stock Market Efficiency

Abstract:     
One of the central hypotheses of behavioural finance is that stock prices systematically overreact. The seminal study is DeBondt and Thaler (1985), which appears to show that past winners (stocks that have earned the highest positive abnormal returns during the pre-formation period) tend to exhibit negative abnormal returns during the post-formation period, and similarly that past losers (stocks that have earned the greatest negative abnormal returns during the pre-formation period) tend to exhibit positive abnormal returns during the post-formation period. Pre- and post-formation periods range from one year to five years. It is further reported that stocks that have 'overreacted' the most, i.e. where the pre-formation period is longer, and hence where the abnormal returns are more extreme, tend to exhibit a correspondingly greater 'correction' during the post-formation period. The ensuing debate has focussed mainly on whether the results can be explained by a risk-premium story. However, the question has also been raised as to whether the purported overreaction effect actually exists at all, or whether it is merely an artefact created by data or methodological biases. The present study addresses the second of these issues, by carrying out an overreaction study using a new survivorship and look-ahead bias-free database on the UK stock market, SFD Capital UK Fully Listed Version 2.1, and using both cumulative abnormal return and holding period return methodologies in computing long-term returns. Using cumulative abnormal returns largely corroborates the results of DeBondt and Thaler (1985), while using holding period returns finds no evidence of overreaction. It is argued that the main results of the paper provide further evidence for weak form efficiency in the UK stock market.

Keywords: Market Overreaction, Market Efficiency, UK Equities Market, SFD Capital, Behavioural Finance

JEL Classification: G10, G14

working papers series