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Testing Behavioral Finance Theories Using Trends and Sequences in Financial Performance

Author

Listed:
  • Chan, Wesley
  • Frankel, Richard
  • Kothari, S.P.

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

Suggested Citation

  • Chan, Wesley & Frankel, Richard & Kothari, S.P., 2002. "Testing Behavioral Finance Theories Using Trends and Sequences in Financial Performance," Working papers 4375-02, Massachusetts Institute of Technology (MIT), Sloan School of Management.
  • Handle: RePEc:mit:sloanp:1765
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    File URL: http://hdl.handle.net/1721.1/1765
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    References listed on IDEAS

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    Cited by:

    1. Francis, Jennifer & LaFond, Ryan & Olsson, Per & Schipper, Katherine, 2003. "Accounting Anomalies and Information Uncertainty," SIFR Research Report Series 13, Institute for Financial Research.
    2. Jing Chen, 2005. "Information Theory and Market Behavior," Finance 0503009, EconWPA.

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    Keywords

    Behavioral Finance; Behavioral-finance;

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