Title: Investor Psychology and Security Market Under- and Over-reactions

Co-authors: David Hirshleifer, University of Michigan; Avanidhar Subrahmanyam, UCLA

Status: Forthcoming, Journal of Finance

Date of Last Revision: April, 1998


We propose a theory of securities market under- and overreactions based on two well-known psychological biases: investor overconfidence about the precision of private information; and biased self-attribution, which causes asymmetric shifts in investors' confidence as a function of their investment outcomes. We show that overconfidence implies negative long-lag autocorrelations, excess volatility, and, when managerial actions are correlated with stock mispricing, public-event-based return predictability. Biased self-attribution adds positive short-lag autocorrelations (`momentum'), short-run earnings `drift,' but negative correlation between future returns and long-term past stock market and accounting performance. The theory also offers several untested implications and implications for corporate financial policy.

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