Stock market overreaction and the size effect - evidence from the Nairobi Securities Exchange

Abstract

Investors have traditionally been viewed as economically rational individuals who make decisions based on all available information. More recent studies propose that investors are irrational and systematically overreact to good and bad information events. Several anomalies have been identified that deviate from rational behavior, which offer opportunities to make abnormal returns. This paper tests for the overreaction phenomenon, a market anomaly previously presented by De Bandt and Thaler (1985,1987) whereby past losers significantly outperform past winners following overreaction to extreme earnings by investors. The test examines the movement of returns of stocks listed on the Nairobi Securities Exchange over 36 months subsequent to extreme earning years. The test involved forming two portfolios, one of extreme good performers and the other of extreme poor performers during the base year. Performance of these portfolios was analyzed from the year of portfolio formation for 5 overlapping sample periods. As a control, the paper also examines whether the difference between losers and winners is actually a size effect as proposed by Zarowin {1989). Portfolios were formed based on firm size and their performance was analyzed for 36 months subsequent to portfolio formation over 5 overlapping sample periods. The results are however not consistent with either proposition. There was no statistically significant difference between the two portfolios in each case, and therefore the findings do not support both investor overreaction to earnings and the size effect in the NSE.