Cognitive Biases, Downside Risk Shocks, and Stock Expected Returns

Human beings’ decision-making processes are generally influenced by two typical cognitive biases: representativeness heuristic bias and conservatism bias. Previous studies found that the two cognitive biases cause investors to misreact to past stock earnings. This paper argues that the two cognitive biases also cause investors to misreact to past downside risks, thereby resulting in abnormal returns on stocks. We use a pseudo-Bayesian model to characterize how investors with the two cognitive biases incorrectly update their beliefs. The model shows that the combined effect of the two cognitive biases makes the short-term downside risk shock positively related to future stock returns and makes the long-term downside risk shock negatively related to future stock returns. Empirical analysis shows that the anomalous relation mentioned above is widely present in the Chinese A-share market even after controlling for several commonly used firm characteristics. Similar results are also presented in the US stock market. Moreover, we find that more active retail investors and negative investor sentiments can further strengthen the anomalous relation