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Testing Behavioral Finance Theories Using Trends and Sequences in Financial Performance

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  • Chan, Wesley
  • Frankel, Richard
  • Kothari, S.P.
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    Abstract

    Models based on psychological biases can explain momentum and reversal in stock returns, but risk overfitting of theory to data. We examine a central psychological bias, representativeness, which underlies many behavioral-finance theories. According to this bias, individuals form predictions about future outcomes based on how closely past outcomes fit 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 make biased forecasts. We find evidence of short-term accounting momentum, consistent with the idea that investors fail to immediately incorporate new information, but find no support for long-term reversal related to accounting performance. Contrary to theory, we find little evidence that the consistency of past accounting performance is related to future returns

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    File URL: http://hdl.handle.net/1721.1/1765
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    Bibliographic Info

    Paper provided by Massachusetts Institute of Technology (MIT), Sloan School of Management in its series Working papers with number 4375-02.

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    Date of creation: 23 Oct 2002
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    Handle: RePEc:mit:sloanp:1765

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    Postal: MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), SLOAN SCHOOL OF MANAGEMENT, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA
    Phone: 617-253-2659
    Web page: http://mitsloan.mit.edu/
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    Postal: MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), SLOAN SCHOOL OF MANAGEMENT, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA

    Related research

    Keywords: Behavioral Finance; Behavioral-finance;

    References

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    1. Ball, Ray & Kothari, S. P. & Shanken, Jay, 1995. "Problems in measuring portfolio performance An application to contrarian investment strategies," Journal of Financial Economics, Elsevier, Elsevier, vol. 38(1), pages 79-107, May.
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    Cited by:
    1. Jing Chen, 2005. "Information Theory and Market Behavior," Finance, EconWPA 0503009, EconWPA.
    2. Francis, Jennifer & LaFond, Ryan & Olsson, Per & Schipper, Katherine, 2003. "Accounting Anomalies and Information Uncertainty," SIFR Research Report Series, Institute for Financial Research 13, Institute for Financial Research.

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