I investigate the effects of overconfidence on cross-sectional asset returns by observing investors’ responses to market-wide and firm-specific signals. My empirical results show that investors’ overconfidence is more likely to occur for mature firms that are relatively easy to price: i.e. large firms, value firms, dividend-paying firms, firms with more tangible assets, firms with little external financing, and firms with low sales growth. I also find that the effects of investors’ overconfidence on returns are reversed without delay. Therefore, large unexpected responses to signals by overconfident investors explain a significant proportion of short-term return reversals. The average return reversal due to overconfidence is over 1.2% per month for the past four decades and still significant despite the active arbitrage trading in the 2000s.
Keywords: Overconfidence, Contrarian behavior, Response to Signal
JEL codes: G02, G12.
