Market overreaction and underreaction: Tests of the directional and magnitude effects

Frank J. Fabozzi, Chun Yip Fung, Kin Lam, Wing Keung WONG

    Research output: Contribution to journalArticlepeer-review

    19 Citations (Scopus)

    Abstract

    We investigate whether the US equity market exhibits underreaction or overreaction. More specifically, we study the directional and magnitude effects associated with abnormal market reaction. The directional effect is the phenomenon that an extreme price movement will be followed by a price movement in the opposite (overreaction hypothesis) or same (underreaction hypothesis) direction. The magnitude effect is the phenomenon that the more extreme the initial price movement is, the greater the subsequent adjustment will be. In this article, we study both effects by considering extreme, medium and mild winner-loser portfolios. The directional effect is assessed by the profits generated by these portfolios, and the magnitude effect is assessed by comparing the difference in profits between these portfolios. Three tests are developed and applied to test the magnitude effect. Empirically we find support for both of these effects for extreme, medium and mild winner-loser portfolios.

    Original languageEnglish
    Pages (from-to)1469-1482
    Number of pages14
    JournalApplied Financial Economics
    Volume23
    Issue number18
    DOIs
    Publication statusPublished - Sep 2013

    Scopus Subject Areas

    • Finance
    • Economics and Econometrics

    User-Defined Keywords

    • contrarian strategy
    • directional effect
    • loser portfolio
    • magnitude effect
    • momentum strategy
    • overreaction hypothesis
    • underreaction hypothesis
    • winner portfolio

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