Cognitive biases, downside risk shocks, and stock expected returns

This paper finds that the pricing effect of past stock downside risks in stock markets is greatly influenced by two cognitive biases: the representativeness heuristic bias and the conservatism bias. The two cognitive biases can cause investors to misreact to past downside risks of stocks, resulting in abnormal returns. Using the pseudo-Bayesian model, we theoretically describe how investors' incorrect belief updates, influenced by two cognitive biases regarding downside risks of a stock, affect future stock returns under four scenarios. Our empirical analysis confirms that biased beliefs lead to a positive correlation between short-term downside risk shocks and future stock returns, while a negative correlation exists between long-term downside risk shocks and future stock returns. This phenomenon is prevalent in the Chinese A-share market, even after controlling for several commonly used firm characteristics. Similar results are also observed in the US stock market. Furthermore, more active retail investors and low investor sentiments can strengthen the anomalous relation.