Investor Composition and Overreaction

Do stock price run-ups predictably revert? We develop a model of financial markets with two types of investors: rational investors and “oversensitive” investors who react excessively to salient public news. The model yields a summary statistic for the degree to which a stock price has overreacted to news: the gap in holdings between oversensitive and rational investors. We compute this measure empirically using quarterly institutional holdings data. We first measure each investor’s news sensitivity using their tendency to purchase stocks that have experienced positive earnings announcements. Consistent with our model’s premise, we find that news sensitivity is a persistent investor characteristic. We next aggregate our investor-level measure to the stock level to compute the asset-level holdings gap between oversensitive and rational investors. A larger holdings gap forecasts less continuation in stock prices, and greater reversals in the long-run, especially for extreme price run-ups. Furthermore, our holdings gap aggregates several distinct channels of overreaction, including both price extrapolation and overreaction to non-price information.