Over-reliance on Previous Periods' Earnings Can Cause Post-Earnings-Announcement Drift and Over-Reactions to Extreme Performance

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Abstract
This paper uses a laboratory experiment to show that investors systematically over-rely on firms' previous performance levels: when previous performance is high (low), prices are too high (low). This error creates two types of anomalies. Too much reliance on previous levels gives the appearance that investors under-react to changes in performance from that level. Prices therefore remain too low (high) after large increases (decreases) in performance, similar to the post-earnings-announcement drift anomaly. Too much reliance on previous levels also gives the appearance that investors overestimate the degree to which extreme performance in prior periods leads to extreme performance in the target period. Prices therefore remain too high (low) after persistently strong (weak) performance, similar to the long-term over-reaction anomaly. The results therefore suggest that these two anomalies may be caused by a single behavioral effect.