Overreaction

Arithmetic Mean

What is an overreaction in finance and investment?

The overreaction is an emotional response to new information. In finance and investment, it is an emotional response to security like an action or other investment, which is driven either by greed or fear. Investors, overreacting to the news, cause the security to be overbought or oversold until it returns to its intrinsic value.

Key points to remember

  • An overreaction in the financial markets occurs when prices become overbought or oversold for psychological rather than fundamental reasons.
  • Bubbles and crashes are examples of excessive upward and downward reactions, respectively.
  • The efficient market hypothesis prevents over-reaction, but behavioral finance predicts that they happen – and that smart investors can take advantage of them.

How excessive reactions work

Investors are not always rational. Instead of pricing all information known to the public perfectly and instantly, as the efficient market hypothesis assumes, it is often affected by cognitive and emotional bias.

Some of the most influential work in behavioral finance has focused on the initial under-reaction and the subsequent over-reaction of prices to new information. And many funds are now using behavioral funding strategies to exploit these biases in their portfolios, particularly in less efficient markets like small-cap stocks.

Funds looking to take advantage of an overreaction are looking for companies whose stock prices have been depressed by bad earnings news, but where the news is likely to be temporary. Low-priced stocks, otherwise known as value stocks, are one example.

Unlike overreaction, under-reaction to new information is more likely to be permanent and is caused by anchoring, a term that describes people’s attachment to old information, which is especially strong when that information is essential. to a consistent way of explaining the world. (also known as hermeneutics) owned by the investor. Grounding ideas like “brick and mortar retail stores are dead” can cause investors to miss undervalued stocks and profit opportunities.

Examples of overreaction

All asset bubbles are examples of an overreaction, from the tulip madness in Holland in the 17th century to the meteoric rise of cryptocurrencies in 2020.

Asset bubbles form when the rise in the price of an asset begins to attract investors as the main source of return rather than the fundamental returns offered by the asset. For stocks, the “fundamental” return is the growth of the company and possibly the dividend offered by the share.

The “fundamental return” of a tulip bulb in the 1600s was the beauty of the flower it produced, which is a difficult result to quantify. Because investors did not have a good way of measuring the desirability of light bulbs, the price was used as the metric, and because the price of light bulbs was always increasing, it created the unfounded belief that light bulbs were worth intrinsic – and a good investment.

The upside overreaction continues until the smart money starts to leave the investment, in which case the stock’s value starts to fall, producing an excessive downward reaction. In the case of the Dotcom bubble of the late 1990s and early 2000s, the market correction put many unprofitable companies out of business, but it also lowered the value of good stocks to favorable levels. Amazon.com Inc. (AMZN) peaked before the dotcom bubble burst at $ 86.88 on December 6, 1999 and fell to its low of $ 6.98 in September 2001, a loss of 92, 5%. Since then, the stock has appreciated by almost 5,000%.

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