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Looking at the Evidence

The debate about whether markets overreact to new information or follow a random walk will never be resolved with theoretical arguments. Both sides are entrenched in their views and are unlikely to be swayed by arguments from the other side. You can, however, look at the empirical evidence to see which hypothesis is more justified by the evidence. In this section, you will look at two sets of studies that may shed light on this question. The first group examines whether price changes in one period are related to price changes in previous periods and indirectly answer the question of whether markets reverse themselves over time. The second group tries to directly answer the question by examining whether investing in stocks that have gone down the most over a recent period is a worthwhile strategy.

Serial Correlation

If today is a big up day for a stock, what does this tell you about tomorrow? There are three different points of view. The first is that the momentum from today will carry into tomorrow and that tomorrow is more likely to be an up day than a down day. The second is that there will be the proverbial profit taking as investors cash in their profits and that the resulting correction will make it more likely that tomorrow will be a down day. The third is that each day you begin anew, with new information and new worries, and that what happened today has no implications for what will happen tomorrow.


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