We propose a theory of securities market under-and overreactions based on two well-known psychological biases: investor overconfidence about the precision of private information; and biased self-attribution, which causes asymmetric shifts in investors' confidence as a function of their investment outcomes. We show that overconfidence implies negative long-lag autocorrelations, excess volatility, and, when managerial actions are correlated with stock mispricing, public-event-based return predictability. Biased self-attribution adds positive short-lag autocorrelations ("momentum"), short-run earnings "drift," but negative correlation between future returns and long-term past stock market and accounting performrance. The theory also offers several untested implications and implications for corporate financial policy. IN RECENT YEARS

This article develops and applies new measures of portfolio performance which use benchmarks based on the characteristics of stocks held by the portfolios that are evaluated. Specifically, the benchmarks are constructed from the returns of 125 passive portfolios that are matched with stocks held in the evaluated portfolio on the basis of the market capitalization, book‐to‐market, and prior‐year return characteristics of those stocks. Based on these benchmarks, “Characteristic Timing” and “Characteristic Selectivity” measures are developed that detect, respectively, whether portfolio managers successfully time their portfolio weightings on these characteristics and whether managers can select stocks that outperform the average stock having the same characteristics. We apply these measures to a new database of mutual fund holdings covering over 2500 equity funds from 1975 to 1994. Our results show that mutual funds, particularly aggressive‐growth funds, exhibit some selectivity ability, but that funds exhibit no characteristic timing ability.

Firm size and book-to-market ratios are both highly correlated with the returns of common stocks. Fama and French (1993) have argued that the association between these firm characteristics and their stock returns arises because size and book-to-market ratios are proxies for non-diversifiable factor risk. In contrast, the evidence in this paper indicates that the return premia on small capitalization and high book-to-market stocks does not arise because of the comovements of these stocks with pervasive factors. It is the firm characteristics and not the covariance structure of returns that explain the cross-sectional variation in stock returns.

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Capital, and SAC. Moskowitz has an ongoing relationship with AQR Capital, who invests in, among many other things, momentum strategies. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. At least one co-author has disclosed a financial relationship of potential relevance for this research. Further information is available online at http://www.nber.org/papers/w20439.ack NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.