Overreaction is a particular emotional response toward new information. Within the finance and investing world, overreaction behavior refers to an emotional response to security, such as stock or other investment, guided by greed or fear.
Commonly, there is either oversold or overbought due to investors who overreact to the latest news.
How does It Work?
Investors are sometimes, irrational. If the efficient market hypothesis assumes that investors trade all publicly available information directly and perfectly, the truth is, they, almost all the time, get some effects from emotional and cognitive biases.
In behavioral finance, many influential works concern the prices’ direct under-reaction and the later overreaction to the new information. Consequently, we know to see many funds that use behavioral finance strategies in order to gain profit from these biases.
Especially, if they are in a less efficient market and have small-cap stocks. Funds which gain advantages of overreaction, usually look for companies with a depressed share price due to the bad news.
The news is usually about their earnings and temporary. The example of that stock is the stock with low price-to-book, that also known as value stocks.
Other than overreaction, we also have under-reaction. Different from overreaction, under-reaction has a bigger probability to give a permanent effect. It usually happens because of anchoring (it describes a situation, where people are more attached to the old information).
Anchoring usually happened when the information is related to something critical to a coherent way to explain the world (usually known as hermeneutic). The example of anchoring ideas can be, ‘brick and mortar stores are no longer promising.’
That information may make the investors to miss the opportunities to gain profit from undervalued stocks.
The example of market overreaction is all asset bubbles. That example ranges from the tulip mania during the 17th century in Holland to the meteoric rise of cryptocurrencies in 2017.