Are Under- and Over-reaction the Same Matter? A Price Inertia based Account
AbstractTheories on under- and over-reaction in asset prices fall into three types: (1) they are respectively driven by different psychological factors; (2) they are driven by different types of investors; and (3) they reflect un-modeled risk. We design an asset market where information arrives sequentially over time and is revealed asymmetrically to investors. None of the three hypotheses is supported by our data: (1) Investors do not respond differently to public information and private information, and they do not behave in ways that are claimed by multiple psychological models; (2) no groups of investors are identified to drive under- or over-reaction in particular; (3) price deviation from expected payoff cannot be justified by risk metrics. We find that prices react insufficiently to news surprises, possibly because of cautious conservatism on the part of investors and under-reacting drifts outnumber overreacting reversals substantially. Contrary to common beliefs, we find that over-reaction is caused by slow adjustment of prices to surprises, similar to the cause of under-reaction. It is the degree of price inertia that drives the relative frequencies of under- and over-reaction. We propose a simple price inertia theory of under- and over-reaction: when information arrives sequentially over time, the market is characterized by a slow convergence toward intrinsic value; when news surprises are of the same signs, prices falls behind newly updated intrinsic values, manifesting under-reacting drifts; when news surprises change signs, prices again do not adjust quick enough to catch up with the new intrinsic values, manifesting a temporal pattern of overreacting reversals.
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Bibliographic InfoPaper provided by Chapman University, Economic Science Institute in its series Working Papers with number 10-05.
Length: 43 pages
Date of creation: 2010
Date of revision:
Experimental finance; under-reaction; overreaction; behavior; price inertia; risk aversion;
Find related papers by JEL classification:
- C92 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Group Behavior
- D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
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