Overreaction in the Australian equity market: 1974-1997

Abstract

Previous assessment of overreaction in the Australian equity market by Brailsford (1992) and Allen and Prince ( 1995) finds no evidence of performance reversal in loser portfolios and no significant difference between the test period performance of winner and loser portfolios. This result is not consistent with evidence from overseas markets and warrants further examination. Using a more extensive data set we find evidence of performance reversal using naive models of expected return where monthly rebalancing of the portfolio is assumed. This result largely disappears when a buy and hold strategy is employed. After appropriate risk adjustment, performance reversal is evident using rebalancing but again disappears when a buy and hold strategy is used. Further analysis reveals that the loser portfolio is dominated by small firms. When the sample is broken into three size portfolios, a positive return to the arbitrage portfolio is only evident in the smallest size portfolio suggesting the presence of a size effect rather than overreaction. Whatever the source, the lack of liquidity in small capitalisation Australian stocks, along with the transaction costs associated with a rebalancing strategy, suggests that any abnormal returns are not exploitable.