What Is an Overreaction?
Let me explain what an overreaction is in the context of finance and investing. It's essentially an extreme emotional response to new information. When you're dealing with a security like a stock or another investment, this response is often driven by greed or fear. As an investor, if you overreact to news, you might cause the security to become overbought or oversold, but eventually, it should return to its intrinsic value.
Key Takeaways
- An overreaction in financial markets happens when securities become excessively overbought or oversold due to psychological reasons rather than fundamentals.
- Bubbles and crashes are examples of overreactions to the upside and downside, respectively.
- The efficient markets hypothesis precludes the occurrence of overreactions, but behavioral finance predicts that they occur—and that smart investors can take advantage of them.
Understanding Overreactions
You need to understand that investors aren't always rational. Many base their buy and sell decisions on emotional behavior. With 24-hour access to information and news, it's easy to see unwarranted actions. Instead of pricing all publicly known information perfectly and instantly, as the efficient market hypothesis assumes, investors are often swayed by cognitive and emotional biases.
Some of the most influential work in behavioral finance focuses on the initial underreaction and subsequent overreaction of prices to new information. Many funds now use behavioral finance strategies to exploit these biases in their portfolios, especially in less efficient markets such as small-cap stocks.
Funds that seek to take advantage of overreactions look for companies whose shares have been depressed by bad earnings news, but where the news is likely temporary. Low price-to-book stocks, otherwise known as value stocks, are an example of such stocks.
In contrast to overreaction, underreaction to new information is more likely to be permanent. An underreaction is often caused by anchoring, which describes people's attachment to old information, especially when that information is critical to a coherent way of explaining the world held by the investor. Anchoring ideas like 'brick and mortar retail stores are dead' can cause you to overlook undervalued stocks and miss profit opportunities.
Examples of Overreaction
All asset bubbles are examples of overreaction, from the tulip mania in Holland in the 17th century to the meteoric rise of cryptocurrencies in 2017.
Asset bubbles form when the rising price of an asset starts to attract investors as the primary 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 stock.
The 'fundamental return' of a tulip bulb in the 1600s was the beauty of the flower it produced, which is difficult to quantify. Because investors didn't have a good way to measure the desirability of the bulbs, price was used as that metric, and since the price was always going up, it created the unfounded belief that the bulbs were intrinsically valuable—and a good investment.
Overreaction to the upside holds until the smart money begins to exit the investment, at which point the value of the security starts to fall, producing an overreaction to the downside. In the case of the dotcom bubble of the late 1990s and early 2000s, the market correction put many unprofitable businesses out of commission, but also lowered the value of good stocks to bargain levels.
Amazon.com Inc. peaked 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.
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