Stock Price Overreaction Effect: Evidence on Nasdaq Stocks, The

Quarterly Journal of Finance and Accounting, Summer 2005 by Ma, Yulong, Tang, Alex P, Hasan, Tanweer

Recently, there has been an increasing interest in academic research on behavioral finance. R.H. Thaler is among the prominent researchers who recognize the importance of behavioral finance and who pioneered the studies. DeBondt and Thaler (1985) first apply the findings from experimental psychology research to explain the stock price overreaction effect. Overreaction is said to exist in stock markets because investors tend to overweigh the recent information in an attempt to revise their expectations about a firm and consequently they undervalue prior information. This kind of general tendency of the investors in the stock market leads to overvaluation of the prospects of the company with good news and undervaluation of the prospects of the company with bad news. Subsequently, when investors reappraise the pricing of those companies with extreme changes, the prices of those stocks previously considered the best decrease and those previously considered the worst increase. This kind of price change phenomenon in the literature has been termed price reversal.

Empirically, to examine if overreaction exists, DeBondt and Thaler (1985) construct two portfolios of stocks with high abnormal positive and negative returns. They find that extreme changes in stock price are followed by significant stock price changes in the opposite direction. They conclude that this is an example of weak-form market inefficiency. In a follow-up study, DeBondt and Thaler (1987) show that subsequent reversals of stock returns are more pronounced during January than in any other months, even though they have rejected size effect and risk measurement effect.

Using the CRSP weekly data from 1963 to 1981, Howe (1986) finds that stocks with good news experience 30 percent lower returns than the market during the 50-week period following the event, and stocks with bad news experience significantly higher returns than the market during the 20-week period after the event. Howe defines the event as a 50 percent price change in either direction. Similar studies with strong evidence in support of the overreaction hypothesis include Brown and Harlow (1988), Pettengill and Jordan (1990), and Chopra, Lakonishok, and Ritter(1992).

Atkins and DyI (1990) examine the overreaction theory by selecting three stocks with the highest percentage gain and three stocks with the highest percentage loss for each day of 300 randomly selected days during the period 1975 through 1984. They find that the abnormal return for the loser portfolio is significantly positive immediately after the large price drop, but there is no significant price reversal for the winner portfolio immediately after the sharp price increase. They also examine the effect of bid-ask spread on the price reversal and find that the stocks with the highest bid-ask spread earn the largest abnormal returns.

Cox and Peterson (1994) and Akhigbe, Gosnell, and Harikumar (1998) also use the bid-ask spread to examine the overreaction phenomenon. Cox and Peterson's sample consists of NYSE, AMEX, and Nasdaq stocks with one-day price declines of 10 percent or more over the period January 1963 through June 1991. They find significant price reversals for NYSE and AMEX firms before, but not after, October 1987. For Nasdaq stocks, their results show significant price reversals following the event day both before and after October 1987. They find that most of these reversals are due to the bid-ask bounce. They conclude that there is no evidence consistent with the overreaction hypothesis.