Testing Behavioral Finance Theories Using Trends and Sequences in Financial Performance

44 Pages Posted: 20 Aug 2002

See all articles by Wesley S. Chan

Wesley S. Chan

Acadian Asset Management

Richard M. Frankel

Washington University in Saint Louis - Olin Business School

S.P. Kothari

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Date Written: June 2003

Abstract

Assessing the predictive ability of behavioral finance theories using out-of-sample data is important. Without predictive tests, the risk of overfitting theory to data is large considering the potentially boundless set of psychological biases underlying the behavioral explanations for observed security price behavior. We test pricing effects attributed to a central psychological bias, representativeness, which underlies many behavioral-finance theories. This bias influences individuals beliefs about future outcomes based on how closely past outcomes represent certain categories. To produce out-of-sample tests, we use accounting performance to identify these categories and test the idea that investors misclassify firms and thus systematically misprice them. Evidence fails to suggest that trends and sequences of accounting performance, as a proxy for representativeness bias, influence investor expectations to generate return predictability.

JEL Classification: M41, G12

Suggested Citation

Chan, Wesley S. and Frankel, Richard M. and Kothari, S.P., Testing Behavioral Finance Theories Using Trends and Sequences in Financial Performance (June 2003). MIT Sloan Working Paper No. 4375-02. Available at SSRN: https://ssrn.com/abstract=316999 or http://dx.doi.org/10.2139/ssrn.316999

Wesley S. Chan

Acadian Asset Management ( email )

260 Franklin Street
Boston, MA 02110
United States

Richard M. Frankel

Washington University in Saint Louis - Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

S.P. Kothari (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

E52-325
Cambridge, MA 02142
United States
617-253-0994 (Phone)
617-253-0603 (Fax)

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