An Alternative Behavioral Explanation for the MAX Effect

Abstract

Stocks with high maximum daily returns (MAX) in a given month yield low returns in the subsequent month. We thoroughly examine the underlying behavioral mechanism based on stock market and individual trading data. We argue that the short-term return predictability is driven by investor overreaction rather than cumulative prospect theory (CPT) preferences. First, we show empirically that high-MAX stocks are comparably not more attractive for CPT-investors. Second, we observe immediate price reversals and no preference-induced price pressure following the MAX return. Third, in line with theories on information-dependent over- and underreaction, the MAX effect reverses if MAX is caused by earnings announcements. Fourth, the MAX effect only exists for stocks far away from an anchoring point as overreaction is mitigated by anchors. Further, discount brokerage data shows that retail investors' speculative buying pressure for lottery-like stocks cannot explain the specific return patterns associated with the MAX effect.

Keywords: MAX effect, overreaction, CPT-preferences, behavioral mechanisms

JEL Classification: G12, G14, G40