Are under- and over-reaction the same matter? Experimental evidence

Abstract

Many argue that under- and over-reaction in asset prices are caused by inherently different factors. We design an asset market where information arrives sequentially over time to investigate the sources of these phenomena. We find that prices react insufficiently to news surprises and under-reacting drifts outnumber over-reacting reversals substantially. Under-reaction decreases in magnitude when information announcement is perfectly public, but still persists. We reject behavioral explanations based on overconfidence and disposition effect. Contrary to common beliefs, over-reaction patterns are present in our results of predominant slow adjustment of prices to surprises. With the knowledge of intrinsic value, we find that the reversal phase in over-reaction patterns is simply a sluggish adjustment, too. We propose a price inertia theory of under- and over-reaction: when information arrives sequentially over time, the market is characterized by a slow convergence toward intrinsic value; when news surprises are of the same signs, prices falls behind newly updated intrinsic values, manifesting under-reacting drifts; when news surprises change signs, prices again do not adjust quick enough to catch up with the new intrinsic values, manifesting a temporal pattern of seemingly over-reacting reversals.