A Model of Investor Sentiment

Stephen Ross

Research

44 Pages

This paper models how investor psychology can produce both short term underreaction and long term overreaction in stock prices. Investors initially update beliefs too cautiously, then mistake repeated earnings patterns for lasting regimes, even though the model assumes earnings actually follow a random walk.

Key Takeaways

Earnings Drift Persists: Over 60 trading days, highest SUE stocks earned a 4.2% greater risk adjusted cumulative return than lowest SUE stocks.
Value Spread Emerges: Extreme value deciles outperformed glamour deciles by 8% to 10% annually, consistent with longer horizon price reversal.
Model Replicates Both: Simulations covering 2,000 firms across 6 years produce underreaction after individual surprises and overreaction following longer earnings streaks.
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