Overreaction Effect in Nordic Stock Markets: A Quantitative Analysis of a Contrarian Investment Strategy

Abstract

Research in behavioral finance suggests that investors are prone to violate Bayes’ theorem and thus irrationally conform to various heuristics. This challenges the Efficient Market Hypothesis and is reflected in the stock market through overreactions and subsequent price reversals. Our thesis investigates whether such overreactions are affecting stock prices in four Nordic stock markets and sectors, and if such overreactions can be theoretically exploited through a contrarian strategy; selling portfolios of prior winner stocks whilst simultaneously buying portfolios of loser stocks. We also address critique targeted at the Overreaction Hypothesis, such as the January effect. The empirical proof from the Nordics is consistent with what the Overreaction Hypothesis predicts; statistically significant stock price reversals are predictable both on market- and sector level, exclusively based on historical return data, suggesting a significant weak-form market inefficiency.

Keywords: Overreaction Hypothesis, Market Efficiency, Behavioral Finance, Heuristics, Irrationality, Experimental Psychology.