What is an Overreaction?
An overreaction is an intense emotional response to new information. In finance and investing, it refers to investors’ exaggerated reactions—driven by either excitement or panic—towards securities like stocks and other investments. This often results in a security becoming overbought or oversold until it eventually returns to its intrinsic value.
Key Takeaways
- Overreactions in financial markets occur when securities are excessively overbought or oversold due to psychological factors rather than fundamentals.
- Market bubbles and crashes provide clear illustrations of overreactions, with bubbles being extreme upswings and crashes being dramatic downswings.
- While the efficient market hypothesis precludes overreactions, behavioral finance acknowledges their occurrence and suggests that astute investors can capitalize on them.
Understanding Overreactions
Contrary to the notion of rational investing, many investors make decisions based on emotional reactions. The 24-hour news cycle and easy access to information can spur knee-jerk investor actions. Instead of instantly reflecting all available information as per the efficient market hypothesis, investors often fall prey to cognitive and emotional biases.
Behavioral finance studies have demonstrated that initial market underreactions can lead to subsequent overreactions to new information. Many professional funds utilize behavioral finance strategies to exploit these biases, particularly in less efficient markets such as small-cap stocks.
These funds typically hunt for stocks that are undervalued due to temporary negative news. For instance, low price-to-book stocks, also known as value stocks, often fit this description.
On the flip side, an underreaction to new information is usually permanent and is often due to a phenomenon called anchoring. Anchoring refers to investors’ attachment to outdated information, particularly when it forms part of a coherent narrative, like the assumption that brick and mortar retail stores are no longer viable, potentially leading to overlooked undervalued investment opportunities.
Examples of Overreaction
Some of the most famous examples of overreaction include historical asset bubbles, such as the Tulip Mania in 17th-century Holland and the rapid rise of cryptocurrencies in 2017.
Asset bubbles arise when the increasing price of an asset attracts more investors who seek returns based on price inflation rather than the asset’s fundamental value. For example, in the case of stocks, fundamental returns come from the growth of the company and, possibly, dividends.
In the Tulip Mania scenario, the fundamental return of a tulip bulb was its beauty—a subjective measure hard to quantify. Investors used price as a metric to gauge value, leading to a vicious cycle of unsustainable price increases and the mistaken belief that tulip bulbs represented a solid investment.
Overreaction can also flip from enthusiastic buying to panic selling. Consider the dotcom bubble of the late 1990s and early 2000s. During this period, the subsequent market correction led to the demise of many unprofitable dotcom businesses. However, the downturn also offered long-term investment opportunities for strong companies at significantly lower valuations.
An illustrative example is Amazon.com Inc., which saw its stock peak at $106.70 on December 10, 1999, before plummeting to $5.97 in September 2001, marking a 94% loss. Despite this massive loss, Amazon’s average stock price in 2020 soared to $2,680.86, demonstrating the potential for long-term gains despite initial overreactions.
Related Terms: intrinsic value, efficient market hypothesis, behavioral finance, value stocks, tulip mania.
References
- Macrotrends. “Amazon - 24 Year Stock Price History”.
