A Model of Investor Sentiment
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What they found
The authors built a model that produces both underreaction (post-earnings drift, momentum) and overreaction (long-term reversal) from two psychological biases. Investors believe earnings switch between a mean-reverting regime and a trending regime, when in fact earnings follow a random walk. Conservatism makes them slow to update after a single surprise (underreaction), while representativeness makes them extrapolate after a string of surprises in the same direction (overreaction). The model matches the observed pattern of short-run continuation and long-run reversal.
What you can use
- Momentum and long-run reversal can be two sides of the same psychological coin: slow updating followed by over-extrapolation.
- After a string of good earnings surprises, the crowd starts to believe in a trend that is not there; that is when reversal risk is highest.
- A single surprise is usually under-priced; a long streak is usually over-priced.
Caveats
A theoretical model; it does not test the mechanism directly. Competing models (Daniel-Hirshleifer-Subrahmanyam, Hong-Stein) produce similar patterns from different assumptions.
Tags: behavioral, underreaction, overreaction, theory
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.