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

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  • Frank J. Fabozzi
  • Chun-Yip Fung
  • Kin Lam
  • Wing-Keung Wong

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.

Suggested Citation

  • Frank J. Fabozzi & Chun-Yip Fung & Kin Lam & Wing-Keung Wong, 2013. "Market overreaction and underreaction: tests of the directional and magnitude effects," Applied Financial Economics, Taylor & Francis Journals, vol. 23(18), pages 1469-1482, September.
    • Handle: RePEc:taf:apfiec:v:23:y:2013:i:18:p:1469-1482
    DOI: 10.1080/09603107.2013.829200
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    Cited by:

    1. Nguyen Huu Hau & Tran Trung Tinh & Hoa Anh Tuong & Wing-Keung Wong, 2020. "Review of Matrix Theory with Applications in Education and Decision Sciences," Advances in Decision Sciences, Asia University, Taiwan, vol. 24(1), pages 28-69, March.
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    3. Abhinava Tripathi, 2021. "The Arrival of Information and Price Adjustment Across Extreme Quantiles: Global Evidence," IIM Kozhikode Society & Management Review, , vol. 10(1), pages 7-19, January.
    4. Chia-Lin Chang & Michael McAleer & Wing-Keung Wong, 2018. "Management Information, Decision Sciences, and Financial Economics: A Connection," Tinbergen Institute Discussion Papers 18-004/III, Tinbergen Institute.
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    7. Ganesh R & Naresh G & Thiyagarajan S, 2020. "Manifesting Overconfidence Bias and Disposition Effect in the Stock Market," International Journal of Business and Economics, School of Management Development, Feng Chia University, Taichung, Taiwan, vol. 19(3), pages 257-284, December.
    8. Chia-Lin Chang & Michael McAleer & Wing-Keung Wong, 2018. "Big Data, Computational Science, Economics, Finance, Marketing, Management, and Psychology: Connections," JRFM, MDPI, vol. 11(1), pages 1-29, March.
    9. Olfa Chaouachi & Fatma Wy?me Ben Mrad Douagi, 2014. "Overreaction Effect in the Tunisian Stock Market," Journal of Asian Business Strategy, Asian Economic and Social Society, vol. 4(11), pages 134-140, November.
    10. Guo, Xu & McAleer, Michael & Wong, Wing-Keung & Zhu, Lixing, 2017. "A Bayesian approach to excess volatility, short-term underreaction and long-term overreaction during financial crises," The North American Journal of Economics and Finance, Elsevier, vol. 42(C), pages 346-358.
    11. Richard Lu & Chen-Chen Yang & Wing-Keung Wong, 2018. "Time Diversification: Perspectives From The Economic Index Of Riskiness," Annals of Financial Economics (AFE), World Scientific Publishing Co. Pte. Ltd., vol. 13(03), pages 1-15, September.
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    13. Kim-Hung Pho & Thi Diem-Chinh Ho & Tuan-Kiet Tran & Wing-Keung Wong, 2019. "Moment Generating Function, Expectation And Variance Of Ubiquitous Distributions With Applications In Decision Sciences: A Review," Advances in Decision Sciences, Asia University, Taiwan, vol. 23(2), pages 65-150, June.
    14. Olfa Chaouachi & Fatma Wyème Ben Mrad Douagi, 2014. "Overreaction Effect in the Tunisian Stock Market," Journal of Asian Business Strategy, Asian Economic and Social Society, vol. 4(11), pages 134-140.
    15. Tran Thai Ha Nguyen & Massoud Moslehpour & Thi Thuy Van Vo & Wing-Keung Wong, 2020. "State Ownership and Risk-Taking Behavior: An Empirical Approach to Get Better Profitability, Investment, and Trading Strategies for Listed Corporates in Vietnam," Economies, MDPI, vol. 8(2), pages 1-21, June.
    16. Chia-Lin Chang & Michael McAleer & Wing-Keung Wong, 2018. "Decision Sciences, Economics, Finance, Business, Computing, And Big Data: Connections," Advances in Decision Sciences, Asia University, Taiwan, vol. 22(1), pages 36-94, December.
    17. Aviral Kumar Tiwari & Anisul M. Islam & Md. Mohibul Islam, 2019. "Relationship between Exchange Rate and Equity Prices in an Emerging Market: A Continuous Wavelet-based Analysis for Bangladesh," International Journal of Business and Economics, School of Management Development, Feng Chia University, Taichung, Taiwan, vol. 18(2), pages 165-193, September.
    18. Kim-Hung Pho & Tuan-Kiet Tran & Thi Diem-Chinh Ho & Wing-Keung Wong, 2019. "Optimal Solution Techniques in Decision Sciences A Review," Advances in Decision Sciences, Asia University, Taiwan, vol. 23(1), pages 114-161, March.
    19. Chia-Lin Chang & Michael McAleer & Wing-Keung Wong, 2018. "Big Data, Computational Science, Economics, Finance, Marketing, Management, and Psychology: Connections," Journal of Risk and Financial Management, MDPI, Open Access Journal, vol. 11(1), pages 1-29, March.
    20. Bozok, İhsan & Özyıldırım, Süheyla, 2022. "Firm centrality and limited attention," International Review of Economics & Finance, Elsevier, vol. 78(C), pages 483-500.

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