Underreact, under-react, underreaction, under-reaction to new information. Investors underreact to new information because they anchor to their prior beliefs and prior information, which causes a lag before the market fully digests the information eventually reflected in the stock price.
Under-reaction means financial markets underreact to news, creating a persistent drift in the directional price trend of markets and stocks, rather than an immediate jump to fair value suggested by EMH.
Underreaction is some of the most influential work in behavioral finance and has led us to develop systems to exploit these behavioral biases in our investment management.
Underreact is to react with less than appropriate force or intensity.
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 under-reaction and overreaction 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.
“In predicting the future, people tend to get anchored by salient past events. Consequently, they underreact.”
“The underreaction evidence shows that security prices underreact to news such as earnings announcements. If the news is good, prices keep trending up after the initial positive reaction; if the news is bad, prices keep trending down after the initial negative reaction.”
“The momentum evidence briefly described in Chapter 1 is closely related to underreaction, since the positive autocorrelations of returns over relatively short horizons may reflect the slow incorporation of news into stock prices.”
Shleifer [book] p112
Articles citing investor underreaction:
- HONG, H. and J.C. STEIN, 1999. A unified theory of underreaction, momentum trading and overreaction in asset markets. The Journal of Finance. [Cited by 363]
- IKENBERRY, D.L., J. LAKONISHOK and T. VERMAELEN, 1994. Market underreaction to open market share repurchases. [Cited by 254]
- JEGADEESH, N. and S. TITMAN, 1995. Overreaction, delayed reaction, and contrarian profits. Review of Financial Studies. [Cited by 56]
- KANG, J.K., et al., 1999. The underreaction hypothesis and the new issue puzzle: evidence from Japan. Review of Financial Studies.[Cited by 38]
- ABARBANELL, J. and R. LEHAVY, 2003. … Role of Reported Earnings in Explaining Apparent Bias and Over/Underreaction in Analysts’ Earnings …. Journal of Accounting and Economics. [Cited by 34]
- POTESHMAN, A.M., 2001. Underreaction, Overreaction, and Increasing Misreaction to Information in the Options Market. The Journal of Finance. [Cited by 25]
- BOEHME, R.D. and S.M. SORESCU, 2002. The Long-run Performance Following Dividend Initiations and Resumptions: Underreaction or Product of …. The Journal of Finance. [Cited by 24]
- IKENBERRY, D.L. and S. RAMNATH, 2002. Underreaction to Self-Selected News Events: The Case of Stock Splits. Review of Financial Studies. [Cited by 19]
- DREMAN, D. and M. BERRY, 1995. Overreaction, underreaction, and the low-P/E effect. Financial Analysts Journal. [Cited by 16]
- AMIR, E. and Y. GANZACH, 1998. Overreaction and underreaction in analysts’ forecasts. Journal of Economic Behavior and Organization. [Cited by 14]
- SHANE, P. and P. BROUS, 2001. Investor and(Value Line) Analyst Underreaction to Information about Future Earnings: The Corrective …. Journal of Accounting Research. [Cited by 14]
- MIKHAIL, M.B., B.R. WALTHER and R.H. WILLIS, 2003. The effect of experience on security analyst underreaction. Journal of Accounting and Economics. [Cited by 13]
- DAVID, A. and P. VERONESI, 1999. … : Theory and Evidence on the Dynamics of Implied Volatilities and Over-/Underreaction in the Options …. [Cited by 10]
- IKENBERRY, D., J. LAKONISHOK and T. VERMAELEN, 1995. Market underreaction to open market repurchases. Journal of Financial Economics. [Cited by 8]
- KADIYALA, P. and P.R. RAU, 2004. Investor Reaction to Corporate Event Announcements: Underreaction or Overreaction?. The Journal of Business. [Cited by 7]