Evidence on Behavioral Biases in Trading Activity

Abstract

This paper is concerned with how the psychological biases of investors are reflected in trading around earnings announcements. We analyze order imbalances (buy orders less sell orders) following earnings surprises to determine whether traders invest in a manner that is consistent with the representativeness and availability heuristics (manifested respectively by undue extrapolation of perceived patterns in random sequences and overreaction to dramatic or vivid events). We then test whether such trading patterns affect returns. Our stimulus for the representativeness heuristic is a string of same-sign earnings surprises, and that for the availability heuristic is an extreme earnings surprise. Though not justified by subsequent price performance, we uncover evidence that investors extrapolate past trends in earning performance. Specifically, following strings of consecutive positive earnings surprises, the amount of net buying after controlling for other regularities in trading activity is significantly greater than it is after an isolated positive surprise. This difference is increasing in the number of consecutive positive surprises in the string. Furthermore, subsequent to strings, purchasing activity is negatively correlated with returns throughout the remainder of the year. Despite the strong manifestation of representativeness, investors who trade according to an availability heuristic are less conspicuous.