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 such as a stock or other investment, 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.
Key Takeaways
- An overreaction in financial markets is 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
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 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 to be 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, a term that describes people's attachment to old information, which is especially strong when that information is critical to a coherent way of explaining the world (also known as a hermeneutic) held by the investor. Anchoring ideas such as "brick and mortar retail stores are dead" can cause investors to overlook undervalued stocks and miss opportunities to make a profit.
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 a difficult result to quantify. Because investors didn't have a good way to measure the desirability of the bulbs, price was used as that metric, and because the price of bulbs 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.
