HE JOURNAL OF FINANCE· VOL. XL NO.3·JULY1985 Does the Stock Market Overreact? WERNER F M. De bondt and RICHARD THALER* ABSTRACT Research in experimental psychology suggests that, in violation of Bayes'rule, most people tend to"overreact "to unexpected and dramatic news events. This study of market efficiency investigates whether such behavior affects stock prices. The empirical evidence, based on CRSP monthly return data, is consistent with the overreaction hypothesis. Substantial weak form market inefficiencies are discovered. The results also shed new light on the January returns earned by prior"winners"and"losers "Portfolios portfolio formation As ECONOMISTS INTERESTED IN both market behavior and the psychology of individual decision making, we have been struck by the similarity of two sets of mpirical findings Both classes of behavior can be characterized as displaying overreaction. This study was undertaken to investigate the possibility that these phenomena are related by more than just appearance. We begin by describing briefly the individual and market behavior that piqued our interest. The term overreaction carries with it an implicit comparison to some degree of reaction that is considered to be appropriate. what is an appropriate reaction? One class. of tasks which have a well-established norm are probability revision problems for which Bayes'rule prescribes the correct reaction to new information It has now been well-established that Bayes'rule is not an apt characterization of how individuals actually respond to new data(Kahneman et al. [14). In revising their beliefs, individuals tend to overweight recent information and underweight prior(or base rate)data. People seem to make predictions according to a simple matching rule: "The predicted value is selected so that the standing of the case in the distribution of outcomes matches its standing in the distribution of impressions"(Kahneman and Tversky [14, p. 416]). This rule-of-thumb, a instance of what Kahneman and Tversky call the representativeness heuristic violates the basic statistical principal that the extremeness of predictions must be moderated by considerations of predictability Grether [12] has replicated this finding under incentive compatible conditions. There is also considerable evi- dence that the actual expectations of professional security analysts and economic forecasters display the same overreaction bias(for a review, see De Bondt [7]) One of the earliest observations about overreaction in markets was made byJ M. Keynes: .. day-to-day fluctuations in the profits of existing investments University of wisconsin at Madison and Cornell University, respectively. The financial support the C.I.m. Doctoral Fellowship Program(Brussels, Belgium)and the Cornell G Management is gratefully acknowledged. We received helpful comments from Seymour Smidt, Dale Morse, Peter Bernstein, Fischer Black, Robert Jarrow, Edwin Elton, and Ross Watts 793