In 1670, Isaac Newton concluded that “What goes up must come down”. Centuries later Werner DeBondt and Nobel prize winner Richard Thaler reported in their 1986 article, ’Does the stock market overreact’ in the Journal of Finance, that the same was true for the stock market. Most people tend to overreact to unexpected and dramatic news events and eventually stock prices correct.
They explained the overreaction effect as follows:
“If stock prices systematically overshoot, then their reversal should be predictable from past return data alone, with no use of any accounting data such as earnings. Specifically, two hypotheses are suggested: (1) Extreme movements in stock prices will be followed by subsequent price movements in the opposite direction. (2) The more extreme the initial price movement, the greater will be the subsequent adjustment."
De Bondt and Thaler tested this overreaction hypothesis by focusing on stocks that had experienced either extreme capital gains or losses over the last years. They tested this on data for the period 1926-1982, constructed loser and winner portfolios and evaluated the performance of these portfolios for a period up to 5 years after the portfolio construction. When using a 3-year look-back, the loser portfolio outperformed the market by 19.6% over the next 3 years. The winner portfolio underperformed by 5%. The difference between the loser and winner portfolios was 24.6%. They also examined portfolios formed on a 5-year look-back and found that the loser portfolio outperformed the past winner portfolio by 31.9% over the next 5 years. This phenomenon is also called the winner-loser effect and was the first attempt to apply a test for a behavioral principle to the stock market.
The authors also made the following observations:
Glen Arnolds, who published a paper proving the presence of the overreaction effect in the UK, also discovered that returns on the loser portfolio could be further enhanced by applying the Piotroski F-score.
The Return reversal with Piotroski template screen replicates the enhanced loser portfolio by going through the following steps:
Although this theory was later confirmed by papers proving its effectiveness in markets around the world, it's a difficult one to put in practice. In her 1998 Wall Street Journal column headed 'Your money matters: investors' overreactions may yield opportunities in the stock market', Thaler was quoted saying:
It's scary to invest in these stocks. When a group of us thought of putting money on this strategy last year, people chickened out when they saw the list of losers we picked out. They all looked terrible...
De Bondt added:
The theory says I should buy them, but I don't know if I could personally stand it. But then again, maybe I'm overreacting.