In contrast, the tests in this study assess the extent onzero residual return behavior in the period after portfolio formation(t>0) is associated with systematic residual returns in the preformation months (t< 0). We will focus on stocks that have experienced either extreme capital gains or xtreme losses over periods up to five years. In other words, winner"(w)and loser"portfolios(L)are formed conditional upon past excess returns, rather than some firm-generated informational variable such as earnings. on Following Fama [9], the previous arguments can be formalized by writing the fficient market's condition E(Rit -Em(Rt FmiIFi-n=E(untI Ft-1)=0 where F-I represents the complete set of information at time t-1, Rit is the return on security j at t, and Em(Rit| Fr-1)is the expectation of Rit, assessed by the market on the basis of the information set Fm. The efficient market hypothesis implies that e(uwt Ft-1)= E(uu I Ft-1)=0. As explained in the introduction, the overreaction hypothesis, on the other hand, suggests that In order to estimate the relevant residuals, an equilibrium model must be specified. a common procedure is to estimate the parameters of the market model (see e. g, Beaver and Landsman [5). what will happen if the equilibrium model is misspecified? As long as the variation in Em(Rt I Fr-1)is small relative to the movements in uit, the exact specification of the equilibrium model makes little difference to tests of the efficient market hypothesis. For, even if we knew the correct"model of Em(Rit I F1), it would explain only small part of the variation in rit. Since this study investigates the return behavior of specific portfolios over extended periods of time (indeed, as long as a decade), it cannot be merely assumed that model misspecification leaves the conclusions about market effi iency unchanged. Therefore, the empirical analysis is based on three types of return residuals: market-adjusted excess returns; market model residuals; and excess returns that are measured relative to the Sharpe-Lintner version of the CAPM. However, since all three methods are single- index models that follor from the CAPM, misspecification problems may still confound the results De bondt [7 formally derives the econometric biases in the estimated market djusted and market model residuals if the true?"model is multifactor, e.g A,+B Rmt+CiX,+ejt. As a final precaution, he also characterizes the securities in the extreme portfolios in terms of a number of financial variables If there were a persistent tendency for the portfolios to differ on dimensions that may proxy for "risk, then, again, we cannot be sure whether the empirical results It turns out that, whichever of the three types of residuals are used, the results 2 Presumably this same reasoning underlies the c f measuring abnormal security E(R,)equals (where, by assump 1 for all]), rather than more complicated market mo iduals, let along residuals relative to some