Overreaction, Noise Trading And Security Investment Strategy

As one of the key propositions of Behavior Finance and the foundation of Momentum Transaction Strategy, over-reaction issues a great challenge to the hypothesis of Efficient Market Theory. Since the significant research of De Bondt and Thaler(1985), the overreaction has attacted an extensive attention in the academic world. Overreaction now is the focus of the debate between the standard finance and behavioral finance. This paper mainly discusses the overreaction in the stock market.This paper found a great deal of empirical studies made by Chinese researchers on over-reaction on China's security market. Moreover, studies on overreaction in China are still at the early stage of merely phenomenon description and simple empirical simulation. There are few theoretical studies on the formation mechanism of over-reaction and its persistence.Based on the literature review, the author studied the overreaction phenomenon and explained the source of the momentum profits. In particular, the author studied the DHS model and BSV model which are notorious models in overreaction studies. The author studied them into the framework of noise trading.In this paper, The author modified the assumption of the HS model and explained the phenomenon of overreaction and underreaction in the condition of short-selling constraint.In the empirical study part, the author fiound that, in recent years there's over-reaction and under-reaction phenomenon in the A-share market in China, the market is far from being efficient. This shows that, currently the institution of the stock market in China is not well established. There are still some problems with the reform. The investors as a whole are immature. The over-reaction of stock prices of small companies is much more serious than big companies in counterpart, and its reverse-action and correction is much faster.In this empirical study of the investment strategy,the author found that institutional investors used momentum trading strategy only in bull market and that individual investors used contrarian strategies in both bull market and bear market.