Stock prices show a tendency to behave in a manner not consistent with what current finance theory proposes or expects. This gap may be the result of flawed assumptions presently used as a basis in existing theory. Conventional modern finance theory rests on the assumption of investor rationality. Efficient market hypothesis (EMH), representing an integral part of conventional finance theory, further assumes security prices reflect (to varying degrees) all available information as processed by rational investors. Modern portfolio theory (MPT) suggests [1] , a stock's price represents the present value of future expected cash flows and therefore, is dependant on investor's expectations of estimated forecasts of earnings growth rates into the future. Actual short-term stock price behavior indicates anomalies and significant divergences of prices away from fundamental intrinsic values, long-term averages, or expectations as implied by MPT. Behavior Finance takes the approach of understanding these price anomalies through a study of cognitive and emotional biases. This thesis investigates the possibility of investor's making mistakes (through irrational behavior) in their forward expectations of future corporate cash flows, resulting in short-term overreaction to earnings information releases due to influence of representative bias (a cognitive bias).
This proposal attempts to examine the existence, relationship and, impact of overreaction as a determinant of securities price behavior in emerging markets of Far East. The aim of this study is to discover representative bias, a tendency of investors to overweigh most recent information in making future forecasts, as one possible cause leading to overreaction in securities prices. This thesis tests investor responses to corporate earnings announcements, specifically surprises, to determine overreaction behavior and to identify representative bias as the cause of such overreaction. The results may contribute, by offering a missing piece of the puzzle, of understanding stock price behavior (towards the search for a unified theory), into existing research work for behavior finance. In addition, a better understanding of what drives stock prices would be a highly useful forecasting and policy tool for participants concerned with asset pricing.
1.2 Motivation for Research
The field of behavior finance focuses on the question; what drives investor behavior?. It is divided into two main groups. Cognitive and emotional biases which are further sub-divided into two sub-groups, individual and collective biases. Behavior finance has been seeking to discover the causes of investor irrationality within the investment decision-making framework. Significant empirical and theoretical studies have been conducted, which suggest cognitive and emotional biases affect investor rationality. Indeed, the field of behavior finance directly challenges the conventional finance framework, which uses within its paradigm the assumption that investors are rational decision makers, and securities prices reflect all available information (EMH [2] ). However, considerable evidence exists which recognizes that asset prices fluctuate away from their rational values [3] . Conventional finance theory has been unable to explain such divergences based on current asset pricing models [4] .
According to Fung (2006), it seems clear that EMH and CAPM [5] (pillars of the current financial theory), despite mounting evidence against their validity, remain widely in use. One reason for this is the fact that these models cannot be empirically falsified due to their dependence on layers of assumptions, which support each other. The other reason is a lack of an alternative asset-pricing model taking cognitive biases into consideration, which does not exist so far. Behavior finance offers just such an alternative, and after observing price anomalies as a trader in the financial markets, I have become interested in pursuing empirical work in this direction to understand and discover a better way to price financial assets. Furthermore, only limited research exists for capital markets covered by this thesis namely Malaysia, Thailand, and Singapore, despite the fact these markets have outperformed western markets recently and continue to offer potential for future growth.
1.3 Statement of Problem
This thesis focuses on the following problem:
"What is the relationship between representative bias and overreaction, as it relates to individual as well as a series of earnings surprise announcements, on investor behavior in the stock markets of Far East? [6] "
1.4 Research Questions & Objectives
This proposal consists of three components. First, the study aims to discover existence of investor overreaction (derived and tested from stock price behavior) in the stock markets of Malaysia, Thailand, and Singapore based on overreaction hypothesis (ORH) as proposed by Thaler (1985). Thereafter, the second objective of this thesis is to test for overreaction in response to corporate earnings surprises (positive and negative). Third and last objective of the study is to determine if representative bias (cognitive bias) is a source of this investor irrationality, in response to earnings surprises, as demonstrated through price behavior in the respective stock markets.
In other words, to contribute an answer to the key question behavior finance is seeking; what drives investor behavior in the stock markets?, this study tests emerging stock markets of far east for investor overreaction. Subsequently, this thesis focuses on representative bias as one cognitive attribute of investor behavior, which may cause overreaction to occur. Following are some of the research questions this study will attempt to answer.
Research Questions:
This study attempts to answer the following research questions:
Research Question 1: Does investor overreaction exist in emerging stock markets?
Research Question 2: Do investors overreact to positive earnings surprises?
Research Question 3: Do investors overreact to negative earnings surprises?
Research Question 4: Is representative bias present during investor overreaction to earnings surprises?
Research Question 5: Does representative bias cause investor overreaction when earnings surprises are positive?
Research Question 6: Does representative bias cause investor overreaction when earnings surprises are negative?
Research Question 7: What is the relationship between representative bias and overreaction as it relates to a series of earnings surprise announcements, both positive and negative?
1.5 Research Significance
The motivation behind this research is to contribute a better understanding of determinants of stock pricing in the context of investor decision making. The results of this study will be useful in furthering current empirical research on cognitive biases affecting stock price behavior, specifically investor overreaction and representative heuristic, (as it relates to earnings surprises), as well as provide useful understanding for investment decision making, forecasting, and policy making for financial market participants in the asset management field. In addition, contribution towards a piece of the stock-pricing puzzle, as well as further research questions may also be discovered.
1.6 Expected Conclusion
The contribution this research would make is extending current empirical research on cognitive biases affecting stock price behavior, and testing for investor irrationality, specifically investor overreaction and representative heuristic, as it relates to earnings surprises. This study may also provide further understanding of the drivers of stock prices for investment decision-making, forecasting, and policy making relevant to financial market participants. In addition, contribution towards a piece of the stock pricing puzzle, as well as further research questions may be discovered. It seems clear that EMH and CAPM (pillars of the current financial theory), despite mounting evidence against their validity, remain widely in use. Behavior finance seems to offer an alternative to the current financial theory, and therefore latest empirical research in asset pricing, is towards this direction in order to understand and discover a better way to price financial assets.
This thesis expects, based on Thaler's (1985) ORH, investor overreaction in the emerging markets (Malaysia, Thailand, and Singapore) as demonstrated through securities prices to be confirmed through empirical testing. In addition, this study expects to identify representative bias as a source of such overreaction.
This study offers to contribute empirical research towards the field of behavior finance in understanding better the notion of investor irrationality and its consequent impact on asset pricing.
1.7 Literature Review, Methodology & Proposed Outline
These sections are included in full version of the proposal (attached separately).
