Judgmental extrapolation and market overreaction: On the use and disuse of news

Authors

  • Paul B. Andreassen

    1. Harvard University, U.S.A.
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    • Paul B. Andreassen is an Associate Professor in the Department of Psychology at Harvard University: 33 Kirkland Street, Cambridge, MA 02138. His research interests are in judgmental forecasting and causal attribution in both financial and social contexts.


Abstract

The tendency of future stock prices to revert toward the mean of past prices was originally explained by the market overreaction hypothesis, which assumed that recent media reports cause investors to underuse base rate information. However, assuming that investors underweigh older stores of financial information cannot readily explain why mean reversion occurs primarily in January among former losers. An alternative psychological model based on intuitive time-series extrapolation is presented. Investors' forecasts are held to vary as a function of the relative salience of, first, the recent versus the older levels of the price series, and second, the trend component of the price series. News reports, as normally provided by the media, are assumed to affect investors' forecasts by increasing the salience of any trend. Results of two market simulation experiments provided support for this assumption. Ways in which salience effects might account for the anomalies of the mean reversion phenomena are discussed.

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