Stock Market Extinction Hypothesis

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Werner F. M. De Bondt and Richard Thaler conducted a study to investigate the stock market. This study examined the impact the overreaction of market behaviour and the psychology of individual decision making has on stock prices. The main goal of this study was “to test whether the overreaction hypothesis is predictive” (pg. 795). They tested two hypotheses (pg. 795):
1. Extreme movements in stock prices will be followed by subsequent price movements in the opposite direction.
2. The more extreme the initial price movement, the greater will be the subsequent adjustment.
Their findings were published in an article titled “Does the Stock Market Overreact?” in July 1985.
Evaluation of “Does the Stock Market Overreact?”
De Bondt and Thaler based their study mainly off of the research conducted by D. Kahneman and A. Tversky. Bayes Theorem is a formula used to determine the conditional probability of an event occurring based on relevant information (Investopedia, 2016). When new information occurs, one might use that information to predict change in stock prices. However, current research is suggesting that Bayes’ rule is not an accurate representation of how individuals respond to new information (pg. 793). It is believed that people have a tendency to place more importance on recent information than historical information. This theory was supported by J.M. Keyes, who made one of the earliest observations about market overreaction (pg. 793). His observation was
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