Investors Overreact

Overreact, over-react, to information. Investor overreaction is an emotional response to new information about a market or security that is driven by greed or fear.

Investors overreacting to news may cause the security, stock, or market to become overbought or oversold until it returns to a more normal range.

Overreact is to respond more emotionally or forcibly than is justified.

Investors are not always rational the rational actors assumed by earlier economists. Instead of perfectly and instantly pricing in all information perfectly, as the Efficient Market Hypothesis assumes, investors and traders are driven by their emotion and faulty cognitive and behavioral biases.

Investor overreaction and underreaction are a challenge to the Efficient Market Hypothesis in that investors often overreact or underreact to the news. If overreactions and underreactions were symmetrical, these reactions could still be consistent with the Efficient Market Hypothesis. However, investor behavior suggests that there are systematic patterns of overreaction and underreaction. For example, individuals tend to anchor to their beliefs, so they underreact to the news. On the other hand, information that is prominent gets people’s attention so they give it more weight in their decision-making process and in forming new beliefs, resulting in over-reaction. Therefore, price prices stray from their rational value, higher or lower, over periods of time. Becuase of underreaction, prices drift gradually up and down, causing what see observe as price trends.

Overreaction cited in books:

‘…investors overreact to negative news.’
Shefrin (2000)

‘De Bondt and Thaler argued that investors overreact to both bad news and good news. Therefore, overreaction leads past losers to become underpriced and past winners to become overpriced.’
Shefrin (2000)

‘De Bondt and Thaler predicted overreaction based on representativeness. […] a portfolio of extreme losers does outperform the market. However, a careful inspection of the figure shows that the effect is concentrated in the month of January.’
Shefrin (2000) page 42

‘Fama (1998a, 1998b) argues that “apparent overreaction of stock prices to information is about as common as underreaction.’
Shefrin (2000) page 87

‘Rather, what we find is apparent underreaction at short horizons and apparent overreaction at long horizons.’
Shefrin (2000) page 87

‘What we seem to have is overreaction at very short horizons, say less than one month (Lehmann, 1990), momentum possibly due to underreaction for horizons between three and twelve months (Jegadeesh and Titman 1993) and overreaction for periods longer than one year (De Bondt and Thaler 1985, 1987, 1990).’
Shefrin (2000) page 85

‘The overreaction evidence shows that over longer horizons of perhaps three to five years, security prices overreact to consistent patterns of news pointing in the same direction.’
Shleifer (2000) page 112

Overreaction cited in articles and papers: