However, when people see a company's earnings go up several years in a row, they believe they have spotted a trend and think that it is going to continue. Such excessive optimism pushes prices too high and produces effects which support the authors' theory of overreaction. There are also well-known biases in human information processing that would predict underreaction to new pieces of information. One such bias, conservatism, states that once individuals have formed an impression, they are slow to change that impression in the face of new evidence. This corresponds directly to underreaction to news.
Investors remain skeptical about new information and only gradually update their views.
The authors note that while such links between psychology and finance sound plausible to many, a substantial proportion of the academic finance community views them with considerable skepticism. We look to the psychology literature to explain these mistakes and illustrate how they generate the findings in the data. While researchers in behavioral finance continue to develop advanced models of the interplay of psychology and finance, proponents of efficient markets will continue to probe the relationships between risk and return. The debate is far from over. Nicholas Barberis is an assistant professor of finance at the University of Chicago Graduate School of Business.