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

15 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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