We propose a theory of securities market under- and overreactions based on two well-known psychological biases: investor overconfidence about the precision of private information; and biased self-attribution, which causes asymmetric shifts in investors’ confidence as a function of their investment outcomes. We show that overconfidence implies negative long-lag autocorrelations, excess volatility, and, when managerial actions are correlated with stock mispricing, public-event-based return predictability. Biased self-attribution adds positive short-lag autocorrelations ~“momentum”!, short-run earnings “drift,” but negative correlation between future returns and long-term past stock market and accounting performance. The theory also offers several untested implications and implications for corporate financial policy. IN RECENT YEARS A BODY OF evidence on security returns has presented a sharp challenge to the traditional view that securities are rationally priced to ref lect all publicly available information. Some of the more pervasive anomalies can be classified as follows ~Appendix A cites the relevant literature!: 1. Event-based return predictability ~public-event-date average stock returns of the same sign as average subsequent long-run abnormal performance! 2. Short-term momentum ~positive short-term autocorrelation of stock returns, for individual stocks and the market as a whole!

/pdf/investor-psychology-and-security-market-under-and-108faczcym.pdf

Investor Psychology and Security Market Under- and Overreactions

We propose a theory of securities market under- and overreactions based on two well-known psychological biases: investor overconfidence about the precision of private information; and biased self-attribution, which causes asymmetric shifts in investors' confidence as a function of their investment outcomes. We show that overconfidence implies negative long-lag autocorrelations, excess volatility, and, when managerial actions are correlated with stock mispricing, public-event-based return predictability. Biased self-attribution adds positive short-lag autocorrelations (momentum), short-run earnings drift, but negative correlation between future returns and long-term past stock market and accounting performance. The theory also offers several untested implications and implications for corporate financial policy. 
Prepublication version available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2017

Presentation Slides for 'Investor Psychology and Security Market Under and Overreactions'

We review the theory and evidence on IPO activity: why firms go public, why they reward first-day investors with considerable underpricing, and how IPOs perform in the long run. Our perspective is threefold: First, we believe that many IPO phenomena are not stationary. Second, we believe research into share allocation issues is the most promising area of research in IPOs at the moment. Third, we argue that asymmetric information is not the primary driver of many IPO phenomena. Instead, we believe future progress in the literature will come from nonrational and agency conf lict explanations. We describe some promising such alternatives. From 1980 to 2001, the number of companies going public in the United States exceeded one per business day. The number of initial public offerings ~IPOs! has varied from year to year, however, with some years seeing fewer than 100 IPOs, and others seeing more than 400. These IPOs raised $488 billion ~in 2001 dollars! in gross proceeds, an average of $78 million per deal. At the end of the first day of trading, their shares traded on average at 18.8 percent above the price at which the company sold them. For an investor buying shares at the first-day closing price and holding them for three years, IPOs returned 22.6 percent. Still, over three years, the average IPO underperformed the CRSP value-weighted market index by 23.4 percent and underperformed seasoned companies with the same market capitalization and book-to-market ratio by 5.1 percent. In a nutshell, these numbers summarize the patterns in issuing activity, underpricing, and long-run underperformance, which have been the focus of a large theoretical and empirical literature. We survey this literature, focusing on recent papers. Space constraints force us to take a U.S.-centric point of view and to omit a description of the institutional aspects of going public. The interested reader can consult Ellis, Michaely, and O’Hara ~2000!,

/pdf/a-review-of-ipo-activity-pricing-and-allocations-1a6z3hq7ug.pdf

A Review of IPO Activity, Pricing, and Allocations

The basic paradigm of asset pricing is in vibrant f lux. The purely rational approach is being subsumed by a broader approach based upon the psychology of investors. In this approach, security expected returns are determined by both risk and misvaluation. This survey sketches a framework for understanding decision biases, evaluates the a priori arguments and the capital market evidence bearing on the importance of investor psychology for security prices, and reviews recent models.

/pdf/investor-psychology-and-asset-pricing-c95w5p60ck.pdf

Investor Psychology and Asset Pricing

In the 1980s, the average first-day return on initial public offerings (IPOs) was 7%. The average first-day return doubled to almost 15% during 1990-1998, before jumping to 65% during the internet bubble years of 1999-2000 and then reverting to 12% during 2001-2003. We attribute much of the higher underpricing during the bubble period to a changing issuer objective function. We argue that in the later periods there was less focus on maximizing IPO proceeds due to an increased emphasis on research coverage. Furthermore, allocations of hot IPOs to the personal brokerage accounts of issuing firm executives created an incentive to seek rather than avoid underwriters with a reputation for severe underpricing. What explains the severe underpricing of initial public offerings in 1999-2000, when the average first-day return of 65% exceeded any level previously seen before? In this article, we address this and the related question of why IPO underpricing doubled from 7% during 1980-1989 to almost 15% during 1990-1998 before reverting to 12% during the post-bubble period of 20012003. Our goal is to explain low-frequency movements in underpricing (or first-day returns) that occur less often than hot and cold issue markets. We examine three hypotheses for the change in underpricing: 1) the changing risk composition hypothesis, 2) the realignment of incentives hypothesis, and 3) a new hypothesis, the changing issuer objective function hypothesis. The changing issuer objective function hypothesis has two components, the spinning hypothesis and the analyst lust hypothesis. The changing risk composition hypothesis, introduced by Ritter (1984), assumes that riskier IPOs will be underpriced by more than less-risky IPOs. This prediction follows from models where underpricing arises as an equilibrium condition to induce investors to participate in the IPO market. If the proportion of IPOs that represent risky stocks increases, there should be greater average underpricing. Risk can reflect either technological or valuation uncertainty. Although there have been some changes in the characteristics of firms going public, these changes are found to be too minor to explain much of the variation in underpricing over time if there is a stationary risk-return relation. The realignment of incentives and the changing issuer objective function hypotheses both

/pdf/why-has-ipo-underpricing-changed-over-time-gykmqywnng.pdf

Why Has IPO Underpricing Changed Over Time

It is not surprising that corporate insiders earn profits from trading their stocks, but it is surprising that outsiders can earn abnormal returns by mimicking the insider trades using publically available information. We suggest that these anomalous returns are explained by the size and price/earnings ratio effects. Controlling for these factors reduces outsider profits by one-half. The additional assumption of 2 percent transactions costs makes outsider profits zero or negative. Measured insider profits are also greatly reduced by controlling for size and price/earnings effects. Insider profits are a modest 3 percent per annum after deducting a 2 perecnt transactions costs fee.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID903468_code133528.pdf?abstractid=903468&mirid=1&type=2

Market Efficiency and Insider Trading: New Evidence

Insider transactions are not random across growth and value stocks. We find that insider buying climbs as stocks change from growth to value categories. Insider buying is also greater after lower stock returns, and lower after high stock returns. These findings are consistent with a version of overreaction which says that prices of value stocks tend to lie below fundamental values, and prices of growth stocks tend to lie above fundamental values.

Overreaction and Insider Trading: Evidence from Growth and Value Portfolios

That corporate insiders earn profits from stock trading does not surprise most financial economists, but that outsiders can earn abnormal returns by using pub licly-available, insider-trading data constitutes a serious exception to stock-market efficiency. The authors show that this anomaly conti nues to exist despite the publication of studies attesting to its exi stence. They suggest that the anomalous profits to outsiders are a ma nifestation of the size and earnings/price ratio effects. Controlling for these factors reduces outsider profits by half: the additional a ssumption of a 2 percent transactions cost makes outsider profits zer o or negative. Insider profits, after an assumed 2 percent transactio ns cost, are a moderate 3 percent per annum for annual holding period s. Copyright 1988 by the University of Chicago.

Insider transactions are not random across growth and value stocks. We find that insider buying climbs as stocks change from growth to value categories. Insider buying also is greater after low stock returns, and lower after high stock returns. These findings are consistent with a version of overreaction which says that prices of value stocks tend to lie below fundamental values, and prices of growth stocks tend to lie above fundamental values. Do MARKET PRICES REFLECT investor overreaction?1 The purpose of this paper is to provide evidence on this question. However, new evidence is unlikely to change many minds if the findings depend on the newly controversial capital asset pricing model (CAPM) or multifactor models, or if they involve datasnooping.2 We bypass these problems by not using CAPM or a benchmark model, and by examining a new set of data. We measure insider buying and selling in stocks that are ranked by measures such as the ratio of cash flow per share to price per share (CF/P).3 Current practice refers to stocks with low CF/P as growth stocks, and to stocks with high CF/P as value stocks. We examine the direction of insider trades along the growth/value spectrum to see if they are consistent with attempts to profit from market overreaction. By overreaction, we mean price movements that predictably reverse. This experiment does not require an asset-pricing model because we do not examine the returns accruing to insider trades.4

Mir A. Zaman

Papers

Market Efficiency and Insider Trading: New Evidence

Overreaction and Insider Trading: Evidence from Growth and Value Portfolios

Market Efficiency and Insider Trading: New Evidence

Overreaction and Insider Trading: Evidence from Growth and Value Portfolios

Aftermarket support and underpricing of initial public offerings