Testing Behavioral Finance Theories Using Trends and Sequences in Financial Performance

Assessing the predictive ability of behavioral finance theories using out-of-sample data is important. The potentially boundless set of psychological biases underlying the behavioral explanations for observed security price behavior risk over-fitting theory to data. We test pricing effects attributed to a central psychological bias, representativeness, which underlies many behavioral-finance theories. According to this bias, individuals form predictions about future outcomes based on how closely past outcomes fit certain categories. To produce out-of sample tests, we use accounting performance to identify these categories and test the idea that investors misclassify firms and thus systematically misprice them. Evidence fails to suggest that the consistency or pattern of accounting performance, as a proxy for representativeness bias, influences investor expectations such as to generate return predictability. We gratefully acknowledge helpful comments of Jon Lewellen and Sendhil Mullainathan. Trends and Sequences in Financial Performance: A Test of Behavioral Theories