Overreaction
What Is an Overreaction?
An overreaction is an extreme emotional response to new information. In finance and investing, it is an emotional response to a [security](/security, for example, a stock or other investment, which is driven either by greed or fear. Investors going overboard to news make the security become either overbought or oversold until it returns to its intrinsic value.
Figuring out Overreactions
Investors are not rational 100% of the time. Rather than pricing all publicly known information flawlessly and in a flash, as the efficient market hypothesis expects, they are in many cases impacted by cognitive and emotional predispositions.
The absolute most powerful work in behavioral finance concerns the initial underreaction and subsequent overreaction of prices to new information. Many funds currently utilize behavioral finance strategies to take advantage of these predispositions in their portfolios, particularly in less efficient markets like small-cap stocks.
Funds that try to exploit overreactions search for companies whose shares have been depressed by terrible earnings news, yet where the news is probably going to be transitory. Low price-to-book stocks, also called value stocks, are an illustration of such stocks.
As opposed to overreaction, underreaction to new information is bound to be permanent. An underreaction is frequently brought about by anchoring, a term that portrays individuals' attachment to old information, which is particularly strong when that information is critical to an intelligent approach to making sense of the world (otherwise called a hermeneutic) held by the investor. Anchoring thoughts, for example, "physical retail stores are dead" can make investors ignore undervalued stocks and botch opportunities to create a gain.
Instances of Overreaction
All asset bubbles are instances of overreaction, from the tulip mania in Holland in the seventeenth century to the fleeting rise of cryptocurrencies in 2017.
Asset bubbles form while the rising price of an asset begins to draw in investors as the primary source of return, as opposed to the fundamental returns offered by the asset. For stocks, the "fundamental" return is the growth of the company and conceivably the dividend offered by the stock.
The "fundamental return" of a tulip bulb during the 1600s was the magnificence of the flower it created, which is a troublesome outcome to evaluate. Since investors didn't have an effective method for estimating the attractiveness of the bulbs, price was utilized as that measurement, and on the grounds that the price of bulbs was continuously going up, it made the unwarranted conviction that the bulbs were intrinsically significant — and a wise investment.
Overreaction to the upside holds until the smart money starts to exit the investment, at which point the value of the security begins to fall, creating an overreaction to the downside. On account of the dotcom bubble of the late 1990s and mid 2000s, the market correction put numerous unprofitable organizations down and out, yet in addition lowered the value of good stocks to bargain levels.
Amazon.com Inc. topped before the dotcom bubble burst at $106.70 on Dec. 10, 1999, before falling to a low of $5.97 in September of 2001, a 94% loss. In 2020, the average stock price of Amazon was $2,680.86.
Features
- The efficient markets hypothesis blocks the occurrence of overreactions, however behavioral finance predicts that they happen — and that smart investors can exploit them.
- Bubbles and crashes are instances of overreactions to the upside and downside, individually.
- An overreaction in financial markets is when securities become unreasonably overbought or oversold due to mental reasons as opposed to fundamentals.
