Extreme Return Days and the Role of Purchase Prices

Abstract

We provide evidence that purchase prices influence how investors behave towards extreme returns. Using a sample of individual investor trades and extreme return dates, we show that when a stock is trading farther from an investor’s purchase price, the investor is more likely to trade in the direction of the stock’s return. Consistent with a relative overreaction, stocks trading farthest from their average purchase price experience the most extreme returns, which are then followed by greater subsequent reversals. A cross-sectional strategy motivated by these findings earns a monthly alpha of 1.02%.

Keywords: Reference Prices, Over- and Underreaction, Information Processing

JEL Classification: G12, G41