Systematic patterns of behavior. Even if individual investors decided to buy or sell without consulting economic fundamentals, the impact on share prices would still be limited. Only when their irrational behavior is also systematic (that is, when large groups of investors share particular patterns of behavior) should persistent price deviations occur. Hence behavioral-finance theory argues that patterns of overconfidence, overreaction, and overrepresentation are common to many investors and that such groups can be large enough to prevent a company’s share price from reflecting underlying economic fundamentals — at least for some stocks, some of the time.
Limits to arbitrage in financial markets. When investors assume that a company’s recent strong performance alone is an indication of future performance, they may start bidding for shares and drive up the price. Some investors might expect a company that surprises the market in one quarter to go on exceeding expectations. As long as enough other investors notice this myopic overpricing and respond by taking short positions, the share price will fall in line with its underlying indicators.
This sort of arbitrage doesn’t always occur, however. In practice, the costs, complexity, and risks involved in setting up a short position can be too high for individual investors. If, for example, the share price doesn’t return to its fundamental value while they can still hold on to a short position — the so-called noise-trader risk — they may have to sell their holdings at a loss.
Momentum and Other Matters
Two well-known patterns of stock market deviations have received considerable attention in academic studies during the past decade: long-term reversals in share prices and short-term momentum.
First, consider the phenomenon of reversal — high-performing stocks of the past few years typically become low-performing stocks of the next few. Behavioral finance argues that this effect is caused by an overreaction on the part of investors: when they put too much weight on a company’s recent performance, the share price becomes inflated. As additional information becomes available, investors adjust their expectations and a reversal occurs. The same behavior could explain low returns after an initial public offering (IPO), seasoned offerings, a new listing, and so on. Presumably, such companies had a history of strong performance, which was why they went public in the first place.
Momentum, on the other hand, occurs when positive returns for stocks over the past few months are followed by several more months of positive returns. Behavioral-finance theory suggests that this trend results from systematic underreaction: overconservative investors underestimate the true impact of earnings, divestitures, and share repurchases, for example, so stock prices don’t instantaneously react to good or bad news.
But academics are still debating whether irrational investors alone can be blamed for the long-term-reversal and short-term-momentum patterns in returns. Some believe that long-term reversals result merely from incorrect measurements of a stock’s risk premium, because investors ignore the risks associated with a company’s size and market-to-capital ratio. (Eugene F. Fama and Kenneth R. French, “Multifactor Explanations of Asset Pricing Anomalies,” Journal of Finance, 1996, Volume 51, Number 1, pp. 55–84.) These statistics could be a proxy for liquidity and distress risk.