The efficient market hypothesis fails to fully explain market behavior. Behavioral economics is a new field that contributes insights to stock market analysis. Throughout history there have been many panics and crashes, with the most recent one being the 2008 housing bubble. This thesis seeks to find evidence and explain, through behavioral economic theory, why investors panic and behave irrationally to bad news. It will utilize the asymmetric utility function along with other behavioral economic theory to find evidence through the market reaction to good quarterly earnings reports and bad quarterly earnings reports. This thesis hopes to show that good news and bad news of equal magnitude result in different reactions in the stock market, as measured through share price and trading volume.
This thesis analyzes volatility of small capitalization biopharmaceutical stocks after significant one-day price drops. Stock performances after one-day declines of ten percent or greater for companies in the NASDAQ Biotechnology Index were gathered from 2011-2012 to test for evidence of market overreaction. While no substantial evidence was found for overreaction, long-term performance suggested that traders underreact during the initial stock drop, with underreaction most prevalent in stocks seeing an initial one-day drop of at least twenty percent. Overreaction only appeared present when companies saw a stock drop due to negative pipeline results.