Black Swans and Market Overreaction The effect of outliers on the long-term performance of the US stock market. Do investors over- or underreact?

Abstract

Black swan events are unpredictable and rare occurrences that have significant impacts on financial markets. The way in which markets react to these events is a topic of much debate in the literature. This thesis aims to examine the black swan events and their impact on long-term investment performance, as well as the market overreaction to these events. Using historical daily returns of the Dow Jones Industrial Average and the S&P 500 stock index returns, in the first part of the thesis, I quantify the impact of black swans on a $100 investment during the sample period. The findings exhibit the significant impact of a few outliers on an over 100 years long passive investment. In the second part of the thesis, I test market under-/overreaction to extreme negative and extreme positive returns over a 21-day event window. The test of average abnormal returns and cumulative average abnormal returns reveals evidence of market overreaction. This result is inconsistent with the efficient market hypothesis.