Overreaction

Overreaction is an emotional response to new information about a security, which is led either by greed or fear. Investors, overreacting to news, cause the security to become either overbought or oversold, until it returns to its intrinsic value.

Investors are not always rational. Instead of pricing all publicly known information perfectly and instantly, as the efficient market hypothesis assumes, they are often affected by cognitive and emotional biases.

Some of the most influential work in behavioral finance concerns the initial under-reaction and subsequent overreaction of prices to new information. And many funds now use behavioral finance strategies to exploit these biases in their portfolios, especially in less efficient markets like small-cap stocks.

Funds which seek to take advantage of overreaction, seek out companies whose share prices have depressed by bad news about their earnings, but where the news is likely to be temporary. Low price-to-book stocks, otherwise known as value stocks, are an example of such stocks.

In contrast to overreaction, under-reaction to new information is more likely to be permanent, and is caused by anchoring – the attachment to previous information, which can cause a lag before the market has fully digested the implication of some new information.