A Model of Investor Sentiment
Abstract (Via Journal of Financial Economics Harvard)
Recent empirical research in finance has uncovered two families of pervasive regularities: underreaction of stock prices to news such as earnings announcements, and overreaction of stock prices to a series of good or bad news. In this paper, we present a parsimonious model of investor sentiment, or of how investors form beliefs, which is consistent with the empirical findings. The model is based on psychological evidence and produces both underreaction and overreaction for a wide range of parameter values.
Excerpt (Via Journal of Financial Economics Harvard)
The evidence presents a challenge to the effcient markets theory because it suggests that in a variety of markets, sophisticated investors can earn superior returns by taking advantage of underreaction and overreaction without bearing extra risk. The most notable recent attempt to explain the evidence from the efficient markets viewpoint is Fama and French (1996). The authors believe that their three-factor model can account for the overreaction evidence, but not for the continuation of short-term returns (underreaction). This evidence also presents a challenge to behavioral finance theory because early models do not successfully explain the facts.5 The challenge is to explain how investors might form beliefs that lead to both underreaction and overreaction.
In this paper, we propose a parsimonious model of investor sentiment of how investors form beliefs Ð that is consistent with the available statistical evidence. The model is also consistent with experimental evidence on both the failures of individual judgment under uncertainty and the trading patterns of investors in experimental situations. In particular, our specification is consistent with the results of Tversky and Kahneman (1974) on the important behavioral heuristic known as representativeness, or the tendency of experimental subjects to view events as typical or representative of some specific class and to ignore the laws of probability in the process. In the stock market, for example, investors might classify some stocks as growth stocks based on a history of consistent earnings growth, ignoring the likelihood that there are very few companies that just keep growing. Our model also relates to another phenomenon documented in psychology, namely conservatism, defined as the slow updating of models in the face of new evidence (Edwards, 1968). The underreaction evidence in particular is consistent with conservatism. Our model is that of one investor