IV. ConclusionEmpirical securities markets research in the last three decades has presented
a body of evidence with systematic patterns that are not easy to explain
with rational asset pricing models. Some studies conclude that the market
underreacts to information, while others find evidence of overreaction. We
have lacked a theory to integrate this evidence, and to make predictions
about when over- or underreaction will occur.
This work develops a theory based on investor overconfidence and on
changes in confidence resulting from biased self-attribution of investment
outcomes. The theory implies that investors will overreact to private infor-
mation signals and underreact to public information signals. In contrast
with the common correspondence of positive (negative) return autocorrela-
tions with underreaction (overreaction) to new information, we show that
positive return autocorrelations can be a result of continuing overreaction.
This is followed by by long-run correction. Thus, short-run positive auto-
correlations can be consistent with long-run negative autocorrelations.
The theory also offers an explanation for the phenomenon of average
public event stock price reactions of the same sign as postevent long-run ab-
normal returns. This pattern has sometimes been interpreted as market
underreaction to the event. We show that underreaction to new public infor-
mation is neither a necessary nor a sufficient condition for such event-based
predictability. Such predictability can arise from underreaction only if the
event is chosen in response to market mispricing. Alternatively, predictabil-
ity can arise when the public event triggers a continuing overreaction. For
example, postearnings announcement drift may be a continuing overreac-
tion triggered by the earnings announcement to preevent information.
The basic noise trading approach to securities markets (e.g., Grossman
and Stiglitz 1980, Shiller 1984, Kyle 1985, Glosten and Milgrom 1985,
Black 1986, DeLong, Shleifer, Summers, and Waldmann 1990b, and Camp-
bell and Kyle 1993) posits that there is variability in prices arising from un-
predictable trading that seems unrelated to valid information. Our approach
is based on the premise that an important class of mistakes by investors in-
volves the misinterpretation of genuinenew private information. Thus, our
model endogenously generates trading mistakes that are correlated with fun-
damentals. Modeling the decision problems of quasi-rational traders im-
poses restrictions on trade distributions that are not obvious if distributions
are imposed exogenously. This structure provides predictions about the dy-
namic behavior of asset prices which depend on the particular cognitive
error that is assumed. For example, underconfidence also gives rise to quasi-
rational trading that is correlated with fundamentals, but gives rise to em-
pirical predictions which are the reverse of what the empirical literature
finds. Specifically, if informed investors are underconfident (σC^2 >σ^2 ), there
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