generate new empirical implications. The goal of this work is to develop
such a theory of security markets.
Our theory is based on investor overconfidence, and variations in confi-
dence arising from biased self-attribution. The premise of investor overconfi-
dence is derived from a large body of evidence from cognitive psychological
experiments and surveys (summarized in section 1) which shows that individ-
uals overestimate their own abilities in various contexts.
In financial markets, analysts and investors generate information for trad-
ing through means, such as interviewing management, verifying rumors, and
analyzing financial statements, which can be executed with varying degrees
of skill. If an investor overestimates his ability to generate information, or
to identify the significance of existing data that others neglect, he will un-
derestimate his forecast errors. If investors are more overconfident about
signals or assessments with which they have greater personal involvement,
they will tend to be overconfident about the information that they them-
selves have generated but not about public signals. Thus, we define an over-
confidentinvestor as one who overestimates the precision of his private
information signal, but not of information signals publicly received by all.
We find that the overconfident informed overweigh the private signal rela-
tive to the prior, and their trading pushes the price too far in the direction
of the signal. When noisy public information signals arrive, the inefficient de-
viation of the price is partially corrected, on average. On subsequent dates,
as more public information arrives, the price, on average, moves still closer
to the full-information value. Thus, a central theme of this work is that stock
prices overreact to private information signals and underreact to public sig-
nals. We show that this overreaction-correction pattern is consistent with
long-run negative autocorrelation in stock returns, unconditional excess
volatility (unconditional volatility in excess of that which would obtain with
fully rational investors), and with further implications for volatility condi-
tional on the type of signal.
The market’s tendency to over- or underreact to different types of infor-
mation allows us to address the remarkable pattern that the average an-
nouncement date returns in virtually all event studies are of the same sign as
the average postevent abnormal returns. Suppose that the market observes a
public action taken by an informed party such as the firm at least partly in
response to market mispricing. For example, a rationally managed firm may
tend to buy back more of its stock when managers believe their stock is un-
dervalued by the market. In such cases, the corporate event will reflect the
manager’s belief about the market valuation error, and will therefore predict
future abnormal returns. In particular, repurchases, reflecting undervalua-
tion, will predict positive abnormal returns, while equity offerings will pre-
dict the opposite. More generally, actions taken by any informed party (such
as a manager or analyst) in a fashion responsive to mispricing will predict
future returns. Consistent with this implication, many events studied in the
462 DANIEL, HIRSHLEIFER, SUBRAHMANYAM