Investor Attention, Psychological Anchors, and Stock Return Predictability

Abstract

Motivated by psychological evidence on limited investor attention and anchoring, we propose two proxies for the degree to which traders under- and over-react to news, namely, the nearness to the Dow 52-week high and the nearness to the Dow historical high, respectively. We find that nearness to the 52-week high positively predicts future aggregate-market returns, while nearness to the historical high negatively predicts future market returns. We further show that our proxies contain information about future market returns that is not captured by traditional macroeconomic variables and that our results are robust across G7 countries. Comprehensive Monte Carlo simulations and comparisons with the NYSE/AMEX market cap index confirm the significance of these findings.

Keywords: Under-reaction, Over-reaction, Anchor, Behavioral Finance