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Testing Behavioral Finance Theories Using Trends and Sequences in Financial Performance

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