Time Variation in Extrapolation and Anomalies

We find that the degree of extrapolative weighting in investors’ beliefs (DOX) has strong predictive power for a broad set of overreaction-related anomalies in the stock market. The average return spread of these anomalies is about $0.86\%$ per month following high DOX periods and $-0.31\%$ per month following low DOX periods. In sharp contrast, DOX has opposite, but weaker, predictive power for underreaction-related anomalies. In addition, the predictive power of DOX is robust after controlling for a broad set of economic forces. Moreover, most of the DOX effect on long-short anomaly returns derives from the short legs of these overreaction-related anomalies, suggesting that time variation in DOX leads to more time variation in overpricing than in underpricing, probably because of short-sale impediments.

This paper was accepted by Lukas Schmid, finance.

Funding: Z. Su received financial support from Lingnan University [Faculty Research Grants DB25A5 and 103664]. Y. Wang received financial support from the National Natural Science Foundation of China [Grant 72503264]. J. Yu received financial support from the National Natural Science Foundation of China [Grants 72141304 and 72342020].

Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2024.06850.