International Review of Financial Analysis 54 (2017) 54–62

Contents lists available at ScienceDirect

International Review of Financial Analysis

Cognitive biases in investors' behaviour under stress: Evidence from the

London Stock Exchange
Spyridon Kariofyllas a, Dionisis Philippas b,⁎, Costas Siriopoulos c
a
Department of Business Administration, University of Patras, 26504 Rio, Greece
b
Department of Finance, ESSCA School of Management, 55 Quai Alphonse Le Gallo, Boulogne, 92513 Paris, France
c
Zayed University, College of Business, P.O. Box 144534, Abu Dhabi, United Arab Emirates

a r t i c l e i n f o a b s t r a c t

Article history: The paper examines the implications arising from the effect of two cognitive biases, representativeness and con-
Received 5 November 2016 servatism, for securities price behaviour on the London Stock Exchange. In a single- and multi-factor framework
Received in revised form 12 August 2017 of abnormal returns, the aspects of trend and consistency in the performance ratios of UK companies are exam-
Accepted 13 September 2017
ined on the base of behavioural finance theories with respect to cognitive biases. The findings obtained by the
Available online 15 September 2017
multi-factor model confirm the existence of two cognitive biases and trends that investors observe in financial
JEL classification:
performance over the long-term horizon, which is not the case for the single-factor model.
G01 © 2017 Elsevier Inc. All rights reserved.
G02
G12
G14

Keywords:
Cognitive biases
Representativeness
Conservatism

1. Introduction Shleifer, and Vishny (1998), Daniel, Hirshleifer, and Subrahmanyam

The financial performance of companies is subject to performance
measures, changes in the direction of a price trend (price reversals)
and cognitive psychological phenomena. Focusing on cognitive psychol-
ogy, there is a plethora of cognitive biases, such as conservatism, repre-
sentativeness, anchoring, ambiguity aversion and so on, all of which
play a catalytic role in pricing implications and investment decisions.
The predictability of returns, particularly over long horizons, is the re-
sult of time-varying discount rates, which are subject to an efficient
market or systematic mispricing. In this context, price reversals and
market inefficiency are the outputs of investors' information-
processing biases due to the key role of the pervasive cognitive biases,
leading to rejection of the efficient market hypothesis and its validity.
The paper discusses the pricing effects in the London Stock Exchange
(LSE), when investors' information-processing for firms on the basis of
behavioural patterns (i.e. trend and consistency) is determined by two
cognitive biases, conservatism and representativeness, which confirm
(or reject) the validity and forecasting ability of three notable behav-
ioural finance theories of market inefficiency developed by Barberis,
⁎ Corresponding author.
E-mail addresses: skariofylla@upatras.gr (S. Kariofyllas), dionisis.philippas@essca.fr
(D. Philippas), Konstantinos.Syriopoulos@zu.ac.ae (C. Siriopoulos).
(1998) and Hong and Stein (1999). Addressing this issue is a challenge,
as the failure of forecasts, particularly over long horizons, is strongly re-
lated to investors' systematic mispricing of trend and consistency, being
influenced by cognitive biases while processing financial information.
Trend and consistency in the financial information constitute a pattern
of manifestation, incorporating cognitive biases in the information set
used for evaluation. While the consistency of past performance se-
quences may possibly incorporate representativeness biases and there-
fore over-reaction, the lack or even the short-term existence of such
consistency may lead to an under-reaction due to conservatism.1
Even though there is a considerable amount of empirical literature
concerning market inefficiency as the output of investors' information-
processing biases due to systematic mispricing, few studies, to the best
of our knowledge, have examined the influence of cognitive biases,
focusing mainly on US data (see Antoniou, Doukas, & Subrahmanyam,
2013; Chan, Frankel, & Kothari, 2004; Coval & Shumway, 2005;
1
Over-reaction and under-reaction, noted as financial anomalies, are documented pat-
terns of price behaviour that are inconsistent with the predictions of efficient markets and
rational expectations with regard to asset pricing (De Bondt & Thaler, 1985). Behavioural
finance rests on cognitive psychology (systematic errors made by people in the way in
which they think and take decisions) and limits to arbitrage (effectiveness of arbitrage in
different circumstances, limited because of capital requirements, lack of full information,
risk involved in making markets efficient, etc.).

http://dx.doi.org/10.1016/j.irfa.2017.09.003
1057-5219/© 2017 Elsevier Inc. All rights reserved.
 S. Kariofyllas et al. / International Review of Financial Analysis 54 (2017) 54–62
Goetzmann & Kumar, 2008; Stambaugh, Yu, & Yuan, 2012;
Subrahmanyam, 2007) and the Spanish market (Forner & Sanabria,
2010).
In light of the above and to make our arguments comparable to the
benchmark in the related literature, we set up an extended design of hy-
pothesis testing on the basis of patterns of trend and consistency with
respect to an empirical model which uses abnormal returns on
London Stock Exchange firms for single-factor and multi-factor asset
pricing models. This empirical framework employs some model specifi-
cations, adding value to the existing literature by highlighting a number
of important findings and methodological aspects.
Under the first specification, we use a comprehensive dataset com-
prising annual financial information for the financial institutions in the
United Kingdom spanning a period from 1980 to 2012. Our modelling
framework is applied for the full period (1980–2012), as well as for
the period 1980–2006, which is a period before a number of sequential
financial stress events occurred, beginning with the US financial crisis in
2007, thereby addressing cognitive biases in depth by isolating the peri-
od before and whether major stress events are included.
In the second specification, we classify the companies every year
into five equal quintiles based on their growth. Thus, we make a distinc-
tion between financial performance and the company's share price
performance, which is measured using stock returns. This choice of fi-
nancial performance measure provides new insights, complementing
the existing literature (see, for example, Barberis et al., 1998; Chan
et al., 2004; Wu, Wu, & Victor, 2009), which uses earnings due to its sa-
lience and availability. Moreover, it assists in overcoming the systematic
correlation between variables that predict future cash flows and expect-
ed returns, as Fama and French (2006, 2008) and Chen, Novy-Marx, and
Zhang (2011) point out.
The last model specification draws on three hypotheses with respect
to a portfolio strategy for both periods tested by adopting long positions
(high stock growth) and short positions (low stock growth), for compa-
nies that are consistent (or not) for both the upper and lower quintiles.
The idea behind this is to examine the two positions under the influence
of representativeness and conservatism. In line with the studies by
Hirshleifer (2001) and Rubinstein (2001), we examine in and out of
sample whether the consistency of past performance of financial ratios
forecasts the future stock returns of companies, thus assessing the
predictive ability of the behavioural hypotheses. Finally, in an attempt
to expand the hypothesis-testing horizon and consequently provide
evidence over a long-term period, we prolong the period of study
after the portfolio construction by adding one- and two-year lags to all
of the hypothesis tests (i.e. from two years to three and four years).
We test our empirical design by utilising an expanded version of the
Fama-French market risk-free rate model and the three-factor model of
mimicking portfolio (Fama & French, 1993, 1997) and a fourth momen-
tum factor, similar to Carhart's (1997) decomposition of mutual funds
returns. Using the alphas (adjusted returns) for the Fama-French
three-factor and the momentum factor models, we distinguish the ef-
fect of trends and consistency of financial performance beyond returns
or other firms' ratios.
The outcome of our empirical analysis is two main findings of great
importance. The first finding is that, over the long-term horizon, inves-
tors extend the trends that they observe in financial performance in a
stable manner. We argue that a company's financial performance
which has past trends or consistencies leads to foreseeable return be-
haviour. The second important finding is that our results differ from
those in the relevant literature (i.e. Chan et al., 2004; Daniel & Titman,
2006; Forner & Sanabria, 2010) in the case of the multi-factor alphas.
This is particularly the case when we estimate the abnormal returns
using the models that calculate the alphas by adding factors such as
size and momentum.
Our paper adds to the existing literature by innovating in several
ways. Firstly, we enrich the financial performance measures by adding
a profitability ratio that has not previously been used in the relevant
55
literature; that is, the earnings per share ratio. Secondly, we expand
the hypothesis test horizon and we prolong the time period after the
portfolio construction by adding one or two years in all the hypothesis
tests; that is, from two or three years to four years. Our results also high-
light a contradiction to the existing literature for the multi-factor
models, with their alpha values providing strong evidence for the occur-
rence of reversals, demonstrating the over-reaction of investors to-
wards trends and the under-reaction in the processing of performance
information stemming from conservatism bias over the long-term hori-
zon. Finally, our empirical analysis provides an extensive examination of
companies in the UK in a multifactor modelling framework and
comprises the first attempt to do so. Consequently, the findings may
be of great interest concerning the association between behavioural
and international risk factors such as contagion in (and after) a period
of crisis, autonomous policy-making and stress events such as the
recent developments after Brexit, and so on.
The remainder of the paper is organised as follows. Section 2 pre-
sents the empirical design and the testing hypotheses of this study.
Section 3 provides a detailed description of the data. Section 4 develops
the modelling framework and Section 5 discusses the empirical
findings. Finally, Section 6 concludes.
2. Empirical design: cognitive biases and performance
Our study exhibits an extended empirical test design, using trend
and consistency of financial ratios in the London Stock Exchange to con-
firm (or reject) the behavioural finance theories formed by Barberis
et al. (1998), Daniel et al. (1998) and Hong and Stein (1999). These be-
havioural finance theories have been continuously developed over the
last two decades and are based on the existence of the two main cogni-
tive biases (Chan et al., 2004), conservatism and representativeness.
To begin with, it is essential to describe briefly the role of the two
cognitive biases, conservatism and representativeness, in investors' be-
liefs and their impact on pricing effects, assessing the three behavioural
finance theories of market inefficiency for the formation of investor ex-
pectations. Representativeness is the tendency of investors to classify
firms into discrete groups based on similar characteristics. This implies
that consistency in the sequence of past performance causes investors
to place a firm into a group and form predictably biased expectations
about future performance. According to Daniel, Hirshleifer, and Siew
Hong (2002), the pricing implication of representativeness is that inves-
tors might over-extrapolate from past performance and cause overreac-
tion, thereby setting prices too high or too low, which generates return
reversals in the future when expectations are proved false. The promi-
nence of the representativeness can be seen mainly in the halo effect,
where investors observe a positive characteristic of the firm and then
form expectations about other characteristics, and the clustering illusion
and hot hand effects, where investors incorrectly characterise a
sequence of repeated returns as a trend (see, among others, Daniel
et al., 2002; Lakonishok, Shleifer, & Vishny, 1994; Papadamou &
Siriopoulos, 2004; Sirri & Tufano, 1998).
On the other hand, conservatism indicates under-reaction and pre-
dicts momentum in pricing (see Daniel & Titman, 2006; Dechow &
Sloan, 1997; Rabin, 2002). Conservatism is an individual's tendency to
update their beliefs slowly, based on a Bayesian rule, in which they
overweight their prior beliefs and underweight the sample evidence.
The result is that the agent might not revise his or her beliefs about fu-
ture earnings sufficiently upon observing a series of good earnings out-
comes, or there might also be overconfidence based on an individual's
prior information.
Assessing the three behavioural finance theories (hereafter behav-
ioural models), the first behavioural model, developed by Barberis et al.
(1998), assumes that investors permanently adopt faulty methods of pro-
cessing financial information based on the historical data, believing either
that there is a trend or an average return; thus, given the hypothesis of
limited arbitrage, they over- or under-react. An investor's belief is that
56 S. Kariofyllas et al. / International Review of Financial Analysis 54 (2017) 54–62
earnings move between two regimes, the first being one in which earn-
ings follow a mean reverting process (a shock to earnings will be reversed
in the next period) and the second one in which earnings exhibit a trend
(a shock might be followed by an additional shock in the same direction
in the following period). Barberis et al.'s (1998) model relies on both
representativeness and conservatism as the drivers of these incorrect in-
ferences. The biased inferences generate both under- and over-reaction
in prices if arbitrage is limited in capital markets.
The second behavioural model is that of Daniel et al. (1998) and
examines the effects of excessive self-confidence and self-attribution.
Confidence leads to overestimation of personal perceptions and/or in-
formation, as well as underestimation of broad information. Thus, future
behaviour depends to a great extent on past behaviour, i.e. conserva-
tism. On the other hand, due to self-attribution, investors overestimate
the public signals that indicate the validity of the private signals they re-
ceive, thus confirming their confidence, but underestimate uncon-
firmed signals as mere noise. Consequently, investors have too great a
confidence in their abilities as long as the public signals confirm their
private ones. Hence, cumulative good news forms trends in growth
and profits, which in turn lead to a higher share premium and subse-
quent reversal, i.e. representativeness. Finally, Hong and Stein (1999)
assume two heterogeneous groups of investors, based on how they em-
ploy the information available to them. The first group (news watchers)
under-reacts to new information (conservatism), whereas the second
group (momentum traders) extends past information, partially
correcting the biases of the first, but occasionally leading to over-
reaction.
A common assumption in all the models above is that arbitrage
forces are limited and therefore cannot eliminate systematic
mispricing resulting from investors' biased information processing.
We note that neither Daniel et al.'s (1998) nor Hong and Stein's
(1999) models draw on representativeness or conservatism per se
in terms of motivating the behaviour of investors. However, in both
models, the assumptions made can be viewed as operationally simi-
lar to investors' inferences subject to the representativeness and/or
conservatism heuristics applied on the basis of the consistency of
prior company performance. The pricing implications arising from
biased self-attribution in Daniel et al. (1998) are more relevant in
studying trends and consistency of performance, because investors
become increasingly overconfident as public signals confirm their
private signals, leading to an upward trend in expectations and
overpriced stocks due to biased self-attribution and thereby
representativeness.
In light of the above, we set out the specifications of our empirical
design which we use in the modelling framework. Based on repre-
sentativeness, we start with the assumption that investors use con-
sistent growth rates from the past to place companies in three
groups and thereby create biased expectations and mis-valued
stocks. The first group contains the companies with high growth:
this is considered by the investors and consequently investors over-
estimate them. The second group contains the companies with low
growth: investors expect their growth rate to decay and hence they
underestimate them. The remaining companies are considered
non-trending companies, a group that was initially introduced by
Chan et al. (2004). This group refers to the companies that exhibit a
circular motion in their ratios, leading investors to believe they will
revert to past performance. This approach was adopted by Barberis
et al. (1998) in their term “mean-reverting”.
Taking into consideration that the longer the period over which in-
vestors observe a trend, the easier it is for them to rank a company in
an aforementioned group, the observation period is here considered to
be five years. Therefore, our first hypothesis, which is derived from
the pricing implication of representativeness (Daniel et al., 2002), pre-
dicts return reversals while evidence of long-term reversals is noted
by De Bondt and Thaler (1985, 1987) and Ball, Kothari, and Shanken
(1995).
Hypothesis I. Companies will experience a reversal in returns after a
long period of exceptional performance, due to representativeness.
After the formation of trending, representativeness suggests that
consistency of performance will influence the investor sentiment (opti-
mist or pessimist). The more consistent the performance, the greater
the bias will be. In this context, our second hypothesis predicts that
companies with a more consistent prior performance will face a greater
momentum of return reversal—i.e. conservatism.
Hypothesis II. Companies will experience a greater reversal in returns
after a long period of continuous and exceptional performance, com-
pared to companies with non-continuous exceptional performance.
Finally, following the approach of Chan et al. (2004) about
confirming and disconfirming signals, we state our third hypothesis as
follows:
Hypothesis III. Following an unconfirmed signal, companies with pre-
vious continuous exceptional performance will experience a greater re-
versal in returns compared to companies with previous non-contiguous
exceptional performance.
Next, we establish the process with regard to testing the three hy-
potheses based on trend and consistency. Firstly, we establish a scale
for trend by classifying the companies into five equal quintiles based
on their growth in each year. The upper quintile contains the 20% of
companies with the highest growth in the five-year period in terms of
each ratio. There are then three intermediate categories, previously
mentioned as “non-trading”, and finally the lower quintile, which con-
tains the 20% of companies with the lowest growth. To examine the pos-
sibility that investors react to financial performance according to the
three behavioural models, we have applied strategic trading, introduced
by Chan et al. (2004), thereby creating two portfolios: (i) high stock
growth, classified as the long position; (ii) low stock growth, classified
as the short position. We hold these portfolios from the month of the
portfolio construction to forty-eight months ahead without
restructuring. If the differences between the performances of both
long and short portfolios result in a negative sign, Hypothesis I is
confirmed.
To construct a measure of consistency, we initially follow the
classification above. Then, for each of the two extreme quintiles
(upper and lower), we classify the companies based on the consis-
tency of performance within each. Hence, for the upper group of
companies, if the growth rate of a company is above the median for
at least four of the five years (recalculated every year), it is consid-
ered to be stable and is characterised as “consistent”; otherwise, it
is considered unstable and characterised as “inconsistent”. Once
again, we create two portfolios with respect to the long and the
short positions. The first portfolio consists of those companies
proved in the two-step process to be consistent for both the upper
and lower quintiles; the second portfolio comprises those companies
characterised as inconsistent for the upper and lower quintiles, fol-
lowing the same trading strategy. The differences in the performance
of the portfolios thus structured must also be negative to confirm
Hypothesis II.
Finally, to test Hypothesis III—i.e. the relationship between the con-
sistency (or not) of the previous financial performance and the reaction
of investors, as well as the confirmation or rejection of the forecast—we
initially follow the ranking of companies in Hypothesis II. Then, we
perform tests to observe the performance of each company at a time
point that follows the “consistent” or “inconsistent” period. If the
performance is above the median of the reference period, we character-
ise it as a “confirming” (otherwise “disconfirming”) company. Following
this new classification, we again create long portfolios consisting
of “confirming” companies and short portfolios consisting of
“disconfirming” companies. The differences must be negative to confirm
Hypothesis III.
 S. Kariofyllas et al. / International Review of Financial Analysis 54 (2017) 54–62 57

Following the strategy setting given above, representativeness af- Table 1

fects the first portfolio, while conservatism affects the second. Behav- Description of UK company ratios.

ioural models forecast more negative performances of the portfolio Five-year period Returns EPS OIPS NIPS SPS
that includes the consistent shares in which the shareholder has strong 1980–1985 493 411 417 0 410
belief than in the portfolio that includes the inconsistent shares. This oc- 1986–1990 549 539 539 18 531
curs because investors' uptake of an unconfirmed signal is delayed—i.e. 1991–1995 634 647 650 61 646
the prices of the high-growth rate companies will gradually languish, 1996–2000 899 927 925 487 930
2001–2005 1099 1135 1136 1078 1139
while the prices of the low-growth rate companies will recover. Indeed,
2006–2012 1425 1426 1490 1420 1490
the more stable a company's past performance, the more intense the re- Total 5099 5085 5157 3064 5146
versal is bound to be and, as a consequence, a negative difference is also
Note: The table presents a description of the companies with five-years of annual data, for
expected in contrast to the inconsistent companies. It should also be the ratios of interest.
noted that during the testing of Hypothesis III, the window of portfolio
observation and strategic differences is extended to four years, as op-
posed to two years in Chan et al. (2004), to observe the differences in the Bank of England in 2009 and so on. In this context, we can examine
behaviour—as in the case of the previous two tests—over the long term. whether the consistency of past financial performance in the period
To interpret our results, we derive implications taking into consider- without major stress events, which comprises the overall trend, predicts
ation two assumptions. The first is that the investors' behaviour on the future returns, including the stress period, hence providing a compara-
LSE market exhibits no serious differentiation from that of other major tive analysis of how investors' perception changed under the pressure of
international financial hubs (e.g. the US market), in contrast with the stress observed in the UK financial system over these years such as the
study of Forner and Sanabria (2010) which focused on the Spanish mar- high pressure experienced in the UK financial sector, particularly in
ket. The UK market portfolio includes foreign assets, domestic and for- 2009.
eign human capital, and real-estate portfolios, offering an extensive Using as a benchmark the FTSE All Share Index, which includes 612
financial infrastructure and international diversification. Moreover, the companies from all sectors, we draw on four accounting ratios for 239
quantitative easing strategy adopted in the UK in 2009 has encouraged UK companies. The ratios of interest are the sales per share ratio
a cumulative boost in asset purchases within a discrete strategy in the (denoted as SPS), the net income per share ratio (denoted as NIPS),
money and capital markets. Consequently, the second assumption is the operating income per share ratio (denoted as OIPS) and the earnings
that arbitrage power is similar to other investigated markets and all in- per share ratio (denoted as EPS), which together show the financial per-
vestors use the same reasoning and are affected by the same biases. formance of a firm's various operations (Barth, Elliott, & Finn, 1999). To
calculate the growth rate of the ratios, we choose companies with at
least five years of available data in the WorldScope database, using the
3. Data selection
formula provided by Thompson Reuters for calculating discrete
changes. Moreover, we add the stock returns of the companies of our
A major part of our sample comes from the Thompson Reuters
sample and we rank the companies according to their last account as
WorldScope database and covers the annual accounting data of financial
at the end of December on the basis of their market performance over
institutions in the UK for the period spanning 1980 to 2012. Moreover,
the previous five years.
we use the database of the University of Exeter Centre for Finance and
We include operating income per share in addition to net income
Investment, which rebalances to control for survivorship bias for the
per share to mitigate the noise in the income measure due to large,
multi-factor models (four-factor model), following Gregory, Tharayan,
one-time items—i.e., special items, as in Chan et al. (2004). In this con-
and Christidis (2013). Accounting for survivorship bias and persistence
text, net income and operating income are divided by a firm's assets
or its reversal effect, we follow a neutral position between the two the-
and then per share to provide computation of the performance mea-
oretical fundamental contrasting views (Brown, Goetzman, Ibbotson, &
sures for periods with negative revenue, because simple earnings per
Ross, 1992; Grinblatt & Titman, 1992),2 avoiding possible drawbacks of
share growth measures are not meaningful in this context. Dividing
the methodological approach and arguing that even with possible survi-
earnings numbers with their corresponding capital base enables us to
vorship bias effect, the approach adopted is substantially different from
interpret the performance in terms of profitability, a common approach
both these views on the issue.
in the literature (see Chan et al., 2004; Fama & French, 2006, 2015;
The timespan was chosen to ensure the robustness of data and the
Sloan, 1996). The use of per share values mitigates the drawback of all
inclusion of significant economic stress events which affected the UK fi-
growth measures, which is that merger and acquisition activity can af-
nancial sector from 2007.3 Our empirical framework is applied for two
fect growth rate measures; moreover, it enhances the cross-sectional
periods; the first one is from 1980 to 2006, where no major stress events
comparability of the performance of firms of different sizes and miti-
occurred that would significantly affect the UK financial sector; the sec-
gates the potential problems of heteroscedasticity in regression testing.
ond is the full time period from 1980 to 2012, which incorporates a
Table 1 provides information concerning the companies with com-
number of stress events occurring after 2007, i.e. the US subprime mort-
plete data, distinguished by ratio and five-year periods, over the period
gage crisis in 2007, the impact of quantitative easing implemented by
studied. The amount of data provides sufficient robustness for an in-
2
depth analysis, particularly as the quantity of company data increased
The existing literature has two theoretical fundamental contrasting views on this as-
pect, focusing on mutual funds' performance and not on strategies. In the first one, Brown
significantly over the years, as shown. Finally, calculating the cross-
et al. (1992) argue that spurious persistence will be induced. In the second, Grinblatt and sectional correlations of the growth rate of the ratios of interest in addi-
Titman (1992) argue that performance reversals or non-persistence are more likely. tion to the capitalisation of the companies, there is no strong correlation
3
Cited examples of stress events are: i) the US subprime mortgage crisis and Lehman between the ratios and/or capitalisation.4
Brothers' bankruptcy in 2007–2008, following a number of announcements of credit
losses and write-downs by banks, mortgage lenders and other institutional investors; ii)
the credit default swaps clearing relating to European entities in July 2009; iii) the 4. Empirical modelling
European sovereign debt crisis starting in 2010 with a rescue package for European coun-
tries; iv) the sharp drop of stock prices in major stock exchanges across the US, Middle This section sets out the modelling framework with respect to the
East, Europe and Asia, caused by contagion of the European sovereign debt crisis and slow
empirical design. Our empirical modelling is consistent with the
economic growth of the US. Moreover, three quantitative easing programmes were imple-
mented by the FED (2008, 2009 and 2012), two by the Bank of England (2009 to 2012) and
4
the liquidity providing/standard tender programme by ECB (2009) in a coordinated move The results of the cross-correlations are not presented here, but are available upon
to ease the credit crunch effects. request.
58 S. Kariofyllas et al. / International Review of Financial Analysis 54 (2017) 54–62

single-factor and the Fama-French three- and four-factor models, which
take the form:

country-specific multi-factor models explain the stock returns to a
Single−factor model : Rp;t −r fr ¼ ap þ βp Rm;t −r fr þ up;t

returns than international models (Fama & French, 1993, 2006, 2008,
Three−factor model : Rp;t −r fr ¼ ap þ βp Rm;t −r fr þ sp SBM t
þ hp HMLt þ up;t


Four−factor model : Rp;t −rfr ¼ ap þ βp Rm;t −r fr þ sp SBMt
þ hp HMLt þ wp WMLt þ up;t
where Rp,t is the return on portfolio p at time t; rfr is the risk-free rate re-
turn at time t proxied by the UK Treasury bill yield; Rm,t is the return on
the market portfolio at time t proxied by the Financial Times All Share
Index; SBMt is the time t value-weighted return of the factor-
mimicking portfolio constructed by the returns of (S)mall (M)inus
(B)ig companies; HMLt is the time t value-weighted return of the
factor-mimicking portfolio constructed by the returns of (H)igh
(M)inus (L)ow book-to-market value companies; and WMLt is the
time t value-weighted return of the factor-mimicking portfolio con-
structed by the returns of (W)inners (M)inus (L)osers in the past peri-
od. The factor loadings βp, sp, hp and wp capture portfolio risk exposures;
ap is the interpretation of the portfolio's abnormal returns; and finally
up , t is the residual of portfolio p at time t. The established scale for
trend is consistent with the abnormal returns for the single-factor and
multi-factor models, equivalent to the intercept of the time series re-
gressions. Finally, stocks are sorted into quintiles according to growth
measures at the end of every year. Therefore, the returns on holdings
of equally weighted portfolios of top quintile stocks and bottom quintile
stocks and the differences between portfolios are calculated.
The choice of this modelling framework is made for a variety of rea-
sons. Firstly, quantitative models in the social science of finance are
metaphors providing a useful framework with figurative knowledge
and epistemologically meaningful form (McGoun, 2003). To the extent
that a scholar should try to examine the financial performance of the
firms using benchmarks, financial relationships are easier to be exam-
ined. The sensitivity of asset returns to overall market fluctuations and
cognitive biases is the risk determined by the relative prices of risky cap-
ital assets (MacKenzie, 2006); thus, diversification is a process that can
be extended to other existing paradigms in social sciences. This can be
achieved with new metaphors developed within the current paradigm
and puzzle-solving robustness (Lagoarde-Segot, 2015), revealing
investors who are influenced by cognitive biases while processing fi-
nancial information. Secondly, the idea behind this choice is that
ð1Þ greater extent and provide better conclusions and descriptions of
2012, 2015; Griffin, 2002; Hou, Xue, & Zhang, 2015). Therefore, the ex-
ð2Þ planations offered draw on different exposures to macroeconomic fac-
tors, different degrees of internationalisation in companies across
countries, different accounting representations and regulations, etc.
ð3Þ (Gregory et al., 2013).
The different versions of asset pricing models for different markets
provide passable descriptions of average returns for portfolios formed
on the basis of size and value, or size and momentum. Fama and
French (2012) argue that in the case of the size-momentum portfolios
in Europe, four-factor asset pricing models are less successful. In the
case of the UK stock market, evidence from Lee, Liu, and Strong
(2007) questions the ability of the three-factor model to control ade-
quately for risk. Bauer, Cosemans, and Schotman (2010) also report
that there is evidence of time-varying betas when using the three-
factor model. Another reason is that portfolios with tilts towards other
anomalies that seem to be related to historical average returns are
more troublesome for the models (Fama & French, 2008). Finally,
there are significant indications lending support for the existence of
two cognitive anomalies in various time periods, as there are numerous
statistically significant reversals in returns that stem from over-
reactions caused by representativeness; on the other hand, there is ev-
idence of under-reaction generated by conservatism bias, which pre-
dicts momentum in returns.
5. Empirical findings
This section presents the empirical findings and discusses the impli-
cations associated with the present research hypotheses for the single-
factor and multi-factor (three- and four-factor) alphas. We address
every research hypothesis separately by presenting the results for the
full period 1980–2012 and the results for the period 1980–2006. More-
over, we use the same structure of panels in every table of results
(panels A, B, C and D) to show the five-year change in performance
for the NIPS, OIPS, SPS and EPS respectively, providing the single-and
multi-factor alphas. Comparing the full period and the period
1980–2006 for every hypothesis tested, we can arrive at conclusions re-
garding the extent to which the sequence of major stress events,

Table 2
Results for Hypothesis I – Full time period.
Note: The table displays the average annual abnormal returns for portfolios over period t and subsequent 1-, 2-, 3- and 4-year periods. The period studied is 1980–2012. The rows illustrate
the single-factor, three-factor and four-factor alphas. Stocks are sorted into quintiles based on growth measures in December of every year. The returns on holding equally weighted port-
folios of top and bottom quintile stocks and the difference between portfolios are calculated. Only the differences are shown in each panel. As the long and short portfolios are formed each
year, the 2-, 3- and 4-year abnormal return measures are from overlapping rolling periods. A star (⁎) and a hashtag (#) denote that the alpha coefficients are significant at the 1% and 5%
levels according to the Newey–West test, respectively.

Periods ahead 0 1 2 3 4

Panel A
Net income per share (difference) Single-factor alphas −0.063 −0.367# −0.247 0.199 0.035
Three-factor alphas 0.065 −0.031 −0.054# −0.007 −0.063⁎
Four-factor alphas 0.108⁎ −0.028 −0.039 −0.006 −0.042

Panel B
Operating income per share (difference) Single-factor alphas −0.063 −0.085 −0.037 −0.098 −0.124⁎
Three-factor alphas 0.009 −0.051⁎ −0.071⁎ −0.091⁎ −0.098⁎
Four-factor alphas 0.008 −0.071⁎ −0.064⁎ −0.089⁎ −0.096⁎

Panel C
Sales per share (difference) Single-factor alphas −0.093 0.003 −0.115# −0.022 −0.062
Three-factor alphas −0.039⁎ −0.059⁎ −0.064⁎ −0.080⁎ −0.086⁎
Four-factor alphas −0.027 −0.056⁎ −0.055⁎ −0.087⁎ −0.077⁎

Panel D
Earnings per share (difference) Single-factor alphas −0.096 −0.013 −0.015 −0.116⁎ −0.180⁎
Three-factor alphas 0.016 −0.048⁎ −0.066⁎ −0.073⁎ −0.063⁎
Four-factor alphas 0.023 −0.054⁎ −0.051⁎ −0.077⁎ −0.066⁎
 S. Kariofyllas et al. / International Review of Financial Analysis 54 (2017) 54–62 59

Table 3
Results for Hypothesis I – Period 1980–2006.
Note: The table displays average annual abnormal returns for portfolios over periods ahead and subsequent 1-, 2-, 3- and 4-year periods. The time period spans from 1980 to 2006. The
rows illustrate the single-factor, three-factor and four-factor alphas. Stocks are sorted into quintiles based on growth measures in December of every year. The returns on holding equally
weighted portfolios of top and bottom quintile stocks and the difference between portfolios are calculated. Only the differences are shown in each panel. As the long and short portfolios are
formed each year, the 2-, 3- and 4-year abnormal return measures are from overlapping rolling periods. A star (⁎) and a hashtag (#) denote that the alpha coefficients are significant at the
1% and 5% levels according to the Newey–West test, respectively.

Periods ahead 0 1 2 3 4

Panel A
Net income per share (difference) Single-factor alphas −0.060 −0.501⁎ −0.285 0.248⁎ 0.038
Three-factor alphas −0.016 −0.069 −0.071# −0.028⁎ −0.073#
Four-factor alphas 0.034 −0.079 −0.070 −0.023# −0.041

Panel B
Operating income per share (difference) Single-factor alphas −0.073 −0.091 0.004 −0.081 −0.123⁎
Three-factor alphas −0.006 −0.061⁎ −0.086⁎ −0.102⁎ −0.099⁎
Four-factor alphas −0.011 −0.090⁎ −0.086⁎ −0.097⁎ −0.106⁎

Panel C
Sales per share (difference) Single-factor alphas −0.095 0.005 −0.101# −0.014 −0.048
Three-factor alphas −0.057⁎ −0.091⁎ −0.078⁎ −0.085⁎ −0.090⁎
Four-factor alphas −0.050⁎ −0.093⁎ −0.065⁎ −0.092⁎ −0.091⁎

Panel D
Earnings per share (difference) Single-factor alphas −0.070 0.015 −0.008 −0.093⁎ −0.183⁎
Three-factor alphas 0.003 −0.056⁎ −0.071⁎ −0.087⁎ −0.066⁎
Four-factor alphas 0.011 −0.071⁎ −0.060⁎ −0.092⁎ −0.070⁎

starting with the US subprime mortgage crisis in 2007, expanded differentiation between the two periods studied, as shown in the tables
dynamically in the following years and influenced the behaviour of above. Finally, we observe that the three- and four-factor alpha values
the companies. show no significant changes from the period 1980–2006 to the full pe-
riod, indicating that performance trends generate systematic reversal.
5.1. Empirical results for Hypothesis I
5.2. Empirical results for Hypothesis II
Tables 2 and 3 show the annual averages of abnormal returns for the
two periods studied, being the differences in the equally weighted com-
Our second research hypothesis addresses the extent to which com-
ponents of the quotas for the upper and lower quintiles (portfolios) dur-
panies with consistent financial performance produce more reversals in
ing the formation year plus one, two, three and four years following.
returns and fewer trends in comparison with companies with inconsis-
Each panel in the tables shows the single- and multi-factor alphas for
tent performance. A given firm-year is consistent with the high growth
the companies classified on the basis of the five-year change in perfor-
(low growth) trend if it is above (below) the median growth of other
mance for all the ratios of interest. Panel A shows firms sorted by the
contemporaneous firm-years.5 Within the top and bottom quintiles,
change in net income per share from five years previously to the last
firm-year observations are consistent (inconsistent) if all five or four
year, divided by total assets per share from five years previously. Panel
(three or fewer) sub-years of growth are consistent with the five-year
B shows firms sorted by the change in operating income per share
trend. Tables 4 and 5 display the annual averages for the abnormal
from five years previously to the last year, treated in the same way as
returns from the equally weighted components of the quotas for the dif-
panel A. Panel C shows firms sorted by change in sales per share from
ferences in the upper and lower quintiles (portfolios) in the formation
five years previously to the last year. Finally, panel D shows firms sorted
year plus one, two, three and four years following, for the full period
by earnings per share treated in the same way as panel C.
and the period 1980–2006.
When examining the results of the single-factor model in Table 3, the
Each panel in the tables shows the single- and multi-factor alphas for
negative alphas become apparent. Hypothesis I is verified four years after
the companies classified on the basis of the five-year change in perfor-
portfolio formation in the case of the OIPS ratio, and three and four years
mance for all the ratios of interest. Panel A uses quintiles based on the
after portfolio formation in the case of the EPS ratio. These findings
percentage change in five-year net income per share divided by total as-
provide evidence of similarities in investors' behaviour, in line with the
sets per share in the initial year. Panel B uses quintiles based on the
study by Chan et al. (2004). We next turn to the results derived from
change in five-year operating income per share treated in the same
the calculation of the three- and four-factor alphas for the full period.
way as Panel A. Panel C uses quintiles based on the percentage change
We find that in the case of the OIPS, SPS and EPS, the alpha values are neg-
in five-year sales per share and, finally, panel D uses quintiles based
ative to a large extent for the differences formed by the portfolios, and
on the percentage change in five-year earnings per share.
most of the cases (27 cases) are statistically significant. These findings
In the case of the single-factor alphas, as shown in Table 4, the find-
support our hypothesis that performance trends generate systematic
ings are of minor importance as we find negative values, as expected,
reversal, in line with the study by Lakonishok et al. (1994), who provide
with only two cases that are statistically significant. However, and in
evidence for these values versus the well-notarised stocks.
contrast to the results for Hypothesis I, the findings derived from the
Comparing the results for Hypothesis I for the two periods studied,
multi-factor models for Hypothesis II are quite interesting. We find ev-
we establish that in the case of the single-factor model, the NIPS ratio
idence that the pattern of past financial performance strongly affects
exhibits significant changes in the period 1980–2006 in that the re-
the stock returns, although not as clearly as for Hypothesis I. For all test-
quired negative alpha values for differences are confirmed one and
ing periods and all methods of estimating the alpha coefficients, we
three years after portfolio formation. This does not apply for the entire
period studied. Consequently, it is apparent that the crisis magnified 5
The counts of the UK companies and data to compute the five-year past returns and
the intensity of the phenomenon, most likely because of the removal the five-year past growth rates for the four measures of financial performance are calculat-
of noise traders and the shift in investors adopting a purely fundamental ed. The results of the cross-correlations are not presented here, but are available upon
and conservative approach. Unlike the other three ratios, there is no request.
60 S. Kariofyllas et al. / International Review of Financial Analysis 54 (2017) 54–62

Table 4
Results for Hypothesis II – Full time period.
Note: The table displays the average annual abnormal returns on buying and selling an equally weighted portfolio of top and bottom quintile stocks, respectively, at year t and in subse-
quent 1-, 2-, 3- and 4-year periods. The time period spans from 1980 to 2012. The rows show the difference in long/short returns between consistency groups. A star (⁎) and a hashtag (#)
denote that the alpha coefficients are significant at the 1% and 5% levels according to the Newey–West test, respectively.

Periods ahead 0 1 2 3 4

Panel A
Net income per share (difference) Single-factor alphas −0.153 −0.295 −0.553⁎ −0.332 0.034
Three-factor alphas −0.022 −0.024 0.037 0.039 −0.015
Four-factor alphas −0.018 0.006 0.033 0.090⁎ −0.048

Panel B
Operating income per share (difference) Single-factor alphas −0.253 −0.226 −0.130 −0.089 −0.095
Three-factor alphas −0.105⁎ −0.083⁎ −0.100⁎ −0.057 −0.055
Four-factor alphas −0.149⁎ −0.044 −0.130⁎ −0.083 −0.057

Panel C
Sales per share (difference) Single-factor alphas −0.039 −0.004 −0.178⁎ −0.142 −0.074
Three-factor alphas −0.076⁎ −0.077⁎ −0.026# −0.051# −0.039
Four-factor alphas −0.107⁎ −0.052⁎ −0.044⁎ −0.059# −0.037

Panel D
Earnings per share (difference) Single-factor alphas −0.101 −0.196 −0.269 −0.218 −0.040
Three-factor alphas 0.013 −0.076 −0.086⁎ −0.083 −0.012
Four-factor alphas 0.080 −0.062 −0.093# −0.075 −0.020

observe negative and statistically significant values. However, in the
case of the NIPS ratio for the three-factor model and the EPS ratio for
the four-factor model, we find no statistically significant negative differ-
ences. Therefore, the rejection of Hypothesis II is statistically supported,
albeit not pronounced.
Next, we undertake comparisons for the two periods studied with
respect to Hypothesis II. Starting with the single-factor model, there is
no strategic differentiation in the alpha values between the two periods
examined for any ratio or any time period. This supports the view of the
equivocality of the results for the behavioural dimension of the impact
of the crisis. In contrast to the single-factor model, the results of the
multi-factor models for the period 1980–2006 are as moderate as the
previous ones, supporting the view that the pattern of past financial
performance strongly affects the stock returns, leading to the rejection
of Hypothesis II.
5.3. Empirical results for Hypothesis III
Table 6 displays the results of the strategies analysed to verify
Hypothesis III for the full period and Table 7 displays the relevant results
for the period 1980–2006. Panels A, B, C and D in both tables show the
results on the basis of the five-year change in performance of the NIPS,
OIPS, SPS and EPS respectively. Panel A shows the returns for quintiles
formed based on the change in five-year net income per share divided
by total assets per share in the initial year. In the same way, panel B
shows the returns for quintiles formed based on the change in five-
year operating income per share. Panel C shows the returns for quintiles
formed based on the percentage change in five-year sales per share.
Lastly, panel D shows returns for quintiles formed based on the percent-
age change in five-year earnings per share. In the same manner, a given
firm-year is consistent with the high growth (low growth) trend if it is
above (below) the median growth of other contemporaneous firm-
years. Within the top and bottom growth quintiles, firm-year observa-
tions are considered consistent (inconsistent) if all five or four (three
or fewer) years of sub-period growth are consistent with the five-year
trend.
In the case of the single-factor model for the full time period, we ob-
serve different portfolios with statistically significant negative prices in
two cases, the NIPS ratio and the OIPS ratio, both after four years of port-
folio formation. The findings for the three- and four-factor models for

Table 5
Results for Hypothesis II – Period 1980–2006.
Note: The table displays the average annual abnormal returns on buying and selling an equally weighted portfolio of top and bottom quintile stocks, respectively, over year t and subse-
quent 1-, 2-, 3- and 4-year periods. The time period spans from 1980 to 2006. The rows show the difference in long/short returns between consistency groups. A star (⁎) and a hashtag (#)
denote that the alpha coefficients are significant at the 1% and 5% levels according to the Newey–West test, respectively.

Periods ahead 0 1 2 3 4

Panel A
Net income per share (difference) Single-factor alphas −0.139 −0.666 −0.742⁎ −0.200 −0.182
Three-factor alphas −0.047 0.024 0.112# 0.016 0.001
Four-factor alphas −0.042 −0.013 0.038 0.094⁎ −0.048

Panel B
Operating income per share (difference) Single-factor alphas −0.225 −0.174 −0.170 −0.091 −0.090
Three-factor alphas −0.098⁎ −0.092⁎ −0.107⁎ −0.053 −0.058
Four-factor alphas −0.150⁎ −0.091⁎ −0.106⁎ −0.099 −0.072

Panel C
Sales per share (difference) Single-factor alphas −0.026 −0.020 −0.237⁎ −0.170 −0.050
Three-factor alphas −0.068⁎ −0.072⁎ −0.013 −0.048 −0.048
Four-factor alphas −0.125⁎ −0.039 −0.030 −0.048 −0.049

Panel D
Earnings per share (difference) Single-factor alphas −0.070 −0.189 −0.251 −0.145 −0.073
Three-factor alphas −0.032 −0.096 −0.096# −0.115 0.001
Four-factor alphas −0.024 −0.057 −0.127# −0.102 −0.014
 S. Kariofyllas et al. / International Review of Financial Analysis 54 (2017) 54–62 61

Table 6
Results for Hypothesis III – Full time period.
Note: The table displays the average annual returns on buying and selling an equally weighted portfolio of top and bottom quintile stocks, respectively, in the year that subsequent oper-
ating performance was revealed and the following four years. The period spans from 1980 to 2012. All rows show the differences between consistency groups. A star (⁎) and a hashtag (#)
denote that the alpha coefficients are significant at the 1% and 5% levels according to the Newey–West test, respectively.

Periods ahead 0 1 2 3 4

Panel A
Net income per share (difference) Single-factor alphas −0.259 −0.093 0.005 0.147 0.802#
Three-factor alphas −0.086⁎ −0.053 −0.049# −0.012 −0.018
Four-factor alphas −0.106⁎ −0.014 −0.031 −0.009 −0.023

Panel B
Operating income per share (difference) Single-factor alphas −0.123 0.081 0.400# −0.322# −0.463⁎
Three-factor alphas −0.022 −0.042# −0.034 −0.054# −0.060⁎
Four-factor alphas −0.037 −0.086⁎ 0.004 −0.045 −0.066⁎

Panel C
Sales per share (difference) Single-factor alphas 0.015 0.174 −0.132 −0.122 −0.088#
Three-factor alphas −0.071# −0.126⁎ 0.004 −0.059⁎ −0.022#
Four-factor alphas −0.017 −0.087 −0.003 −0.044⁎ −0.020

Panel D
Earnings per share (difference) Single-factor alphas −0.167 −0.065 −0.008 −0.116 −0.091
Three-factor alphas −0.045# −0.067⁎ −0.071⁎ −0.096⁎ −0.053⁎
Four-factor alphas −0.025 −0.039 −0.090⁎ −0.073⁎ −0.059⁎

Hypothesis III show significant differences in the alpha values from
those in the studies by Chan et al. (2004) and Dechow and Sloan
(1997). Our results indicate that consistent performers exhibit a greater
reversal effect following a disconfirmatory year. We have negative and
statistically significant alpha values for the full period in the majority
of t cases (17 cases). Therefore, the third hypothesis is accepted under
the multi-factor analysis for the period studied. Finally, in the case of
Hypothesis III, the single-factor model shows no differentiation in the
period 1980–2006. There is also no difference in the alpha values in ei-
ther period for the other three ratios. The multi-factor model shows that
20 out of 40 cases have statistically significant negative alphas, meaning
that Hypothesis III is accepted for both periods studied, providing evi-
dence of under-reaction in the processing of performance information
stemming from conservatism bias.
6. Conclusion
Considerable efforts have been made by empirical researchers in re-
cent years to document investor behaviour that relies on representa-
tiveness and conservatism bias at longer horizons, which can lead
investors to form biased expectations of future firm performance. In
the UK, this is vital because the UK financial sector is an international
hub for all types of investor and it raises a series of concerns regarding
the spin-off that could be triggered by momentum and price reversals,
especially with the recent implementation of the Bank of England quan-
titative easing strategy where investors placed firms into groups based
on past performance which were not subsequently realised.
This paper examines the effects of the cognitive biases of representa-
tiveness and conservatism on behavioural investment decisions with
respect to the existence of trends and consistency on the London
Stock Exchange over the period 1980 to 2012. Under single- and
multi-factor model specifications, we examine the extent to which
financial information viewed from a long-term perspective provides
support for the notion that past performance forecasts long-term future
performance, by considering three research hypotheses.
In line with the first hypothesis, the findings indicate the occurrence
of reversals, demonstrating the over-reaction of investors towards trends.
In the second hypothesis, we tested whether the stability of past financial
performance would cause more reversals than momentum. We find
limited evidence that consistency in past growth rates offers amelioration

Table 7
Results for Hypothesis III – Period 1980–2006.
Note: The table presents the average annual returns for buying and selling an equally weighted portfolio of top and bottom quintile stocks, respectively, in the year that subsequent op-
erating performance was revealed and the following four years. The period spans from 1980 to 2006. All rows show the differences between consistency groups. A star (⁎) and a hashtag (#)
denote that the alpha coefficients are significant at the 1% and 5% levels according to the Newey–West test, respectively.

Periods ahead 0 1 2 3 4

Panel A
Net income per share (difference) Single-factor alphas −0.725⁎ −0.077 −0.139 0.162 0.855#
Three-factor alphas −0.070 −0.082⁎ −0.091⁎ 0.034 0.013
Four-factor alphas −0.108 −0.022⁎ −0.050# 0.021 −0.005

Panel B
Operating income per share (difference) Single-factor alphas −0.147 0.057 0.451# −0.320 −0.470⁎
Three-factor alphas −0.033 −0.039 −0.048 −0.059# −0.069⁎
Four-factor alphas −0.074 −0.080⁎ 0.006 −0.040 −0.074⁎

Panel C
Sales per share (difference) Single-factor alphas −0.035 −0.011 −0.040 −0.086 −0.097#
Three-factor alphas −0.046 −0.061⁎ −0.032# −0.074⁎ −0.025#
Four-factor alphas −0.029 −0.035⁎ −0.048⁎ −0.068⁎ −0.019

Panel D
Earnings per share (difference) Single-factor alphas −0.137 0.047 −0.037 −0.094 −0.075
Three-factor alphas −0.065⁎ −0.108⁎ −0.069⁎ −0.092⁎ −0.063⁎
Four-factor alphas −0.050 −0.064⁎ −0.092⁎ −0.076# −0.076⁎
62 S. Kariofyllas et al. / International Review of Financial Analysis 54 (2017) 54–62
in terms of the predictability of returns (representativeness bias). Finally,
we examine whether the confirmation or rejection of established consis-
tency or inconsistency of financial performance can lead to reversals in
the third hypothesis.
Our findings broadly argue that investors' behaviour in terms of
their strategies has a smooth trend during stress periods, as if other
similar events have provided adequate information—and indeed
instruments—to handle a future stress event. Notwithstanding our
findings, the predictability of returns documented in the literature re-
mains an ongoing debate within the topic of market efficiency, posing
challenges to continue testing behavioural finance theories within
recent developments worldwide. Emphasis should also be given to
markets with limited arbitrage and to markets with undisputed debt
crisis characteristics.
Acknowledgements
The authors would like to thank the participants of the 12th Interna-
tional Conference on International Finance, Prato, Italy (2014), for their
constructive comments and suggestions.
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