The Expectations Clock: A Unified Model for Over- and Under-Reaction

51 Pages Posted: 12 Sep 2009

See all articles by G. Kevin Spellman

G. Kevin Spellman

University of Wisconsin-Milwaukee; Instituto de Empresa Business School

Date Written: September 12, 2009

Abstract

The expectations clock illustrates how expectations of future performance are driven by human biases tied to current and past changes in performance. Performance changes over time, so expectations may cycle between improving and declining and high and low. Expectations may be highest when current and past changes in performance are above average, and may be lowest when current and past changes in performance are below average. The clock is a model of over- and under-reaction, and hence, of reversion and momentum. Over- and under-reaction refer to reactions to negative circumstances. Depending on initial expectations, negative events may be disregarded or accentuated in the decision-making process. When expectations are high, negative events may be ignored, resulting in under-reaction and short-term momentum, and when expectations are low, negative circumstances may be over-emphasized, causing over-reaction and long-term reversion.

Keywords: behavioral finance, efficient markets, expectations, expectation, reversion, momentum, overreaction, underreaction, over-reaction, under-reaction, cycles

JEL Classification: G10, G12, G14, G30

Suggested Citation

Spellman, G. Kevin, The Expectations Clock: A Unified Model for Over- and Under-Reaction (September 12, 2009). Available at SSRN: https://ssrn.com/abstract=1472502 or http://dx.doi.org/10.2139/ssrn.1472502

G. Kevin Spellman (Contact Author)

University of Wisconsin-Milwaukee ( email )

Milwaukee, WI 53201-0742
United States
608-334-2110 (Phone)

Instituto de Empresa Business School ( email )

Madrid
Spain
608-334-2110 (Phone)

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