Two Inconsistent Behavioral Biases

Abstract

Our study explores two well-known anomalies that seem to be inconsistent with one another. Investors underreact to extreme quarterly earnings surprises resulting in returns drift that may persist for several quarters. This behavioral bias suggests that investors believe that extreme earnings surprises are mostly transitory during the earnings announcement period, but modify their beliefs later as new information arrives in subsequent quarters. In contrast, investors overreact to extreme performance of mutual funds; they pour more money into mutual funds that have recent outstanding performance and withdraw funds from mutual funds that have recently experienced extreme low performance. As these extreme patterns in performance tend to reverse in subsequent quarters, this behavior by investors suggests they erroneously consider most of the extreme performance to be permanent. We do not attempt to explain this inconsistency for retail investors but provide a potential explanation for this behavior among professional investors.