A General theory of Under-reaction and Overreaction in Stock Market

Abstract Momentum strategy has survived many robust tests, but the existence of its accompanying reversal effects remains in dispute. In this research we modeled a market that contained three types of widely recognized investors: the rational investor, the disposition effect investor, and the trend chaser. Our model shows that if the disposition effect dominates the market, then the stock price under-reacts to news and causes an under-reaction. Conversely, if the trend chasing effect rules the market, then the stock price over-reacts to fundamental changes and this deviation induces a subsequent price reversal. Thus, the market composition of these two effects decides the price (return) patterns, as well as the price volatility relative to fundamental changes. Furthermore, we show that the high trading volume shortens the life of momentum profits, and unrealized capital gains are a less noisy predictor than past fundamental changes. Finally, we also present a simple way to distinguish whether the disposition effect or the trend chasing effect takes control of the market.Index Section I: Introduction 1 Section II: The Model and the Equilibrium 6 II.A: The Model 6 II.B: The Equilibrium 9 Section III: Price and Return Dynamics 15 Section IV: Estimate the Market Composition 23 Section V: Conclusion 31 Reference 3