Chapter 12
A MODEL OF INVESTOR SENTIMENT
Nicholas Barberis, Andrei Shleifer, and
Robert W. Vishny
1.IntroductionRecent empirical research in finance has identified two families of pervasive
regularities: underreaction and overreaction. The underreaction evidence
shows that over horizons of perhaps 1−12 months, security prices underre-
act to news.^1 As a consequence, news is incorporated only slowly into
prices, which tend to exhibit positive autocorrelations over these horizons.
A related way to make this point is to say that current good news has power
in predicting positive returns in the future. The overreaction evidence shows
that over longer horizons of perhaps 3−5 years, security prices overreact to
consistent patterns of news pointing in the same direction. That is, securities
that have had a long record of good news tend to become overpriced and
have low average returns afterwards.^2 Put differently, securities with strings
of good performance, however measured, receive extremely high valuations,
and these valuations, on average, return to the mean.^3
The evidence presents a challenge to the efficient markets theory because
it suggests that in a variety of markets sophisticated investors can earn supe-
rior returns by taking advantage of underreaction and overreaction without
bearing extra risk. The most notable recent attempt to explain the evi-
dence from the efficient markets viewpoint is Fama and French (1996).
We are grateful to the NSF for financial support, and to Oliver Blanchard, Alon Brav, John
Campbell (a referee for the Journal of Financial Economics), John Cochrane, Edward Glaeser,
J. B. Heaton, Danny Kahneman, David Laibson, Owen Lamont, Drazen Prelec, Jay Ritter (a
referee), Ken Singleton, Dick Thaler, an anonymous referee, and the editor, Bill Schwert, for
comments.
(^1) Some of the work in this area, discussed in more detail in section 2, includes Cutler et al.
(1991), Bernard and Thomas (1989), Jegadeesh and Titman (1993), and Chan et al. (1997).
(^2) Some of the work in this area, discussed in more detail in Section 2, includes Cutler et al.
(1991), De Bondt and Thaler (1985), Chopra et al. (1992), Fama and French (1992), Lakon-
ishok et al. (1994), and La Porta (1996).
(^3) There is also some evidence of nonzero return autocorrelations at very short horizons
such as a day (Lehmann, 1990). We do not believe that it is essential for a behavioral model to
confront this evidence because it can be plausibly explained by market microstructure consid-
erations, such as the fluctuation of recorded prices between the bid and the ask.