SFB 303 Discussion Paper No. B - 102

Author: Stock, Detlev
Title: Empirical Tests of the Overreaction Hypothesis for the German Stock Market
Abstract: In two papers, De Bondt and Thaler (1985, 1987) recently investigated a simple stock market trading strategy on the basis of the past half century of data. They were motivated by research in cognitive psychology that has revealed deviations of individual decision-making from the norm of perfect rationality. In several experiments concerning intuitive predictions Kahnemann and Tversky (1982) found out that people tend to put too much emphasis on the most recent information while they underweight or ignore distributional data. It seems that they predict according to the following simple rule: "The predicted value is selected so that the standing in the distribution of outcomes matches its standing in the distribution of impressions" (ibid., p. 416). This rule of thumb, however, does not take into account the fact that the extremeness of predictions must be moderated by considerations of predictability.In a financial setting these findings suggest that investors "overreact" to new information with the consequence that prices temporarily depart from their underlying fundamental values. Therefore, it is more expedient to gather stocks in portfolios which are initially regarded with pessimism than those stocks which already jumped up under the impression of some favorable events. Applying these considerations to a contrarian stock selection strategy, i.e. buying losers and selling winners short, De Bondt and Thaler reported that large abnormal returns could be earned. As their strategy is based on past return data alone, it contradicts the weakest form of market efficiency. A further reason why their work is worth mentioning is the fact that it represents a first attempt to apply a test for a behavioral principle to the stock market.This paper offers the results of empirical tests of De Bondt and Thalerīs "overreaction hypothesis" for the German stock market. Evidence of weak form market inefficiency is found.
Creation-Date: November 1988
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