Testing Behavioral Finance Models of Market Under- and Overreaction: Do They Really Work?
45 Pages Posted: 4 Jan 2006
Date Written: November 29, 2005
Abstract
We test the predictions of the three main behavioral finance theories of market under- and overreaction using out-of-sample data conditional on the nature of the news using the going-concern audit opinion (bad news event) and its withdrawal (good news event). We find strong support for the Daniel, Hirshleifer and Subrahmanyam (1998) model for our bad news as well as the good news case suggesting that market underreaction to going-concern opinions is a consequence of prior market overreaction resulting from incorrect classification of going-concern firms by investors into trending regimes. In contrast, we find no support for the Barberis, Shleifer and Vishny (1998) or Hong and Stein (1999) models in our event-study setting in either the bad or good news cases. Our results have a number of implications relating to the value of such theoretical behavioral finance models in practice. We also highlight the central role of the limits-to-arbitrage assumption when testing such behavioral finance theories.
Keywords: finance, under- and overreaction models, limits to arbitrage, going-concern
JEL Classification: G14, M40
Suggested Citation: Suggested Citation
Do you have negative results from your research you’d like to share?
Recommended Papers
-
How Psychological Pitfalls Generated the Global Financial Crisis
-
Firm and Managerial Incentives to Manipulate the Timing of Project Resolution
By David A. Hirshleifer, Tarun Chordia, ...
-
Excess Comovement in International Equity Markets: Evidence from Cross-Border Mergers
By Ian A. Cooper, Richard A. Brealey, ...
-
The Great Collapse: How Securitization Caused the Subprime Meltdown
By Kurt Eggert
-
Disrupting the Prefrontal Cortex Diminishes the Human Ability to Build a Good Reputation
By Daria Knoch, Frédéric Schneider, ...
-
Striking Regulatory Irons While Hot
By Hersh Shefrin and Meir Statman