We propose a theory of securities market under- and overreactions based on
two well-known psychological biases: investor overconfidence about the
precision of private information; and biased self-attribution, which
causes asymmetric shifts in investors' confidence as a function of their
investment outcomes. We show that overconfidence implies negative long-lag
autocorrelations, excess volatility, and, when managerial actions are
correlated with stock mispricing, public-event-based return
predictability. Biased self-attribution adds positive short-lag
autocorrelations ("momentum"), short-run earnings "drift," but negative
correlation between future returns and long-term past stock market and
accounting performance. The theory also offers several untested
implications and implications for corporate financial policy. Copyright The American Finance Association 1998.
