Week 4

Question 1

How can the reversal effect anomaly be explained by representativeness?

Answer 1

• Investors believe past performance REPRESENTATIVE of future performance –> i.e. ‘winner’ stocks wrongly perceived to perform well in future so overvalued; ‘loser’ stocks wrongly believed to perform poorly in the future so undervalued –> investors OVERREACT to past performance info.
• Eventually overreaction corrected leading to reversal effect where prior ‘losers’ outperform prior ‘winners’ as ‘winner’ stock prices decrease & ‘loser’ stock prices increase –> profitable strategy to buy prior ‘losers’ & sell prior ‘winners.’

Question 2

How can the value effect anomaly be explained by representativeness?

Answer 2

• Investors believe past earnings growth performance REPRESENTS future earnings growth performance.
• ‘Growth’ stocks w high historical earnings growth (high MTB ratios) incorrectly perceived to keep growing rapidly in future so overvalued; ‘value’ stocks w low historical earnings growth (low MTB ratios) incorrectly perceived to keep growing slowly in future so undervalued –> investors OVERREACT to past records of firms’ earnings growth.
• Eventually overreaction corrected leading to value effect where ‘value’ stocks outperform ‘growth’ stocks as ‘growth’ stock prices decrease & ‘value’ stock prices increase –> profitable strategy to buy ‘value’ stocks & sell ‘growth’ stocks.

Question 3

How can the momentum effect anomaly be explained by conservatism?

Answer 3

• Investors UNDERREACT to info about past performance due to conservatism.
• Investors in past stock ‘winners’ fail to fully incorporate this +ve info into stock prices & so undervalue stocks; investors in past stock ‘losers’ fail to fully incorporate this -ve info into stock prices & so overvalue stocks.
• Eventually underreaction corrected leading to momentum effect where past ‘winners’ outperform past ‘losers’ as prices of ‘loser’ stocks decrease & ‘winner’ stocks increase –> profitable strategy to buy ‘winners’ & sell ‘losers’.

Question 4

How can PEAD be explained by conservatism?

Answer 4

• Investors initially UNDERREACT to news e.g. earnings announcements –> fail to fully incorporate earnings announcement info into stock prices.
• Eventually underreaction corrected in following period leading to PEAD –> stocks w good news of earnings announcement see prices continuously rising after initial +ve reactions, earning +ve returns in period after announcement –> for stocks w bad news of earnings announcement, prices continuously decrease after initial -ve reactions, earning -ve returns in period after announcement.

Question 5

Compare representativeness & conservatism?

Answer 5

• Representativeness leads to overreaction to info (influenced too much by latest info) BUT conservatism leads to underreaction to info (latest info not fully taken into consideration).

Question 6

How is representativeness & conservatism explained by Barber’s et al. (1968)?

Answer 6

• Investors first exhibit conservatism & underreact to new info in short run when receiving news about firm –> after investors repeatedly faced w similar news so overreact to info due to representativeness.

Question 7

How can the size effect anomaly be explained by representativeness?

Answer 7

• Investors OVERREACT to info e.g. by extrapolating from past performance –> investors believe firm size REPRESENTATIVE of future performance –> larger firms perceived to perform better so over-valued whereas smaller firms under-valued.
• Eventually overreaction corrected leading to size effect where small firms outperform large firms as prices of large firms decreases & prices of small firms increases –> profitable strategy to buy small firms’ shares & sell large firms’ shares.