Testing Behavioral Finance Theories Using Trends and Sequences in Financial Performance
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Testing Behavioral Finance Theories 4375-02.pdf
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Author(s)
Chan, Wesley
Frankel, Richard
Kothari, S.P.
Date Issued
October 23, 2002
Series/Report no.
MIT Sloan School of Management Working Paper;4375-02
Abstract
Models based on psychological biases can explain momentum and reversal in stock returns, but risk
overfitting of theory to data. We examine a central psychological bias, representativeness, which
underlies many behavioral-finance theories. According to this bias, individuals form predictions about
future outcomes based on how closely past outcomes fit certain categories. To produce out-of sample
tests, we use accounting performance to identify these categories and test the idea that investors
misclassify firms and thus make biased forecasts. We find evidence of short-term accounting
momentum, consistent with the idea that investors fail to immediately incorporate new information, but
find no support for long-term reversal related to accounting performance. Contrary to theory, we find
little evidence that the consistency of past accounting performance is related to future returns
Subjects
Behavioral Finance
Behavioral-finance
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