1. Behavioral Finance: Introduction
  2. Behavioral Finance: Background
  3. Behavioral Finance: Anomalies
  4. Behavioral Finance: Key Concepts - Anchoring
  5. Behavioral Finance: Key Concepts - Mental Accounting
  6. Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias
  7. Behavioral Finance: Key Concepts - Gambler's Fallacy
  8. Behavioral Finance: Key Concepts - Herd Behavior
  9. Behavioral Finance: Key Concepts - Overconfidence
  10. Behavioral Finance: Key Concepts - Overreaction and Availability Bias
  11. Behavioral Finance: Key Concepts - Prospect Theory
  12. Behavioral Finance: Conclusion

By Albert Phung

Key Concept No.7: Overreaction and the Availability Bias
One consequence of having emotion in the stock market is the overreaction toward new information. According to market efficiency, new information should more or less be reflected instantly in a security's price. For example, good news should raise a business' share price accordingly, and that gain in share price should not decline if no new information has been released since.

Reality, however, tends to contradict this theory. Oftentimes, participants in the stock market predictably overreact to new information, creating a larger-than-appropriate effect on a security's price. Furthermore, it also appears that this price surge is not a permanent trend - although the price change is usually sudden and sizable, the surge erodes over time.

Winners and Losers
In 1985, behavioral finance academics Werner De Bondt and Richard Thaler released a study in the Journal of Finance called "Does the Market Overreact?" In this study, the two examined returns on the New York Stock Exchange for a three-year period. From these stocks, they separated the best 35 performing stocks into a "winners portfolio" and the worst 35 performing stocks were then added to a "losers portfolio". De Bondt and Thaler then tracked each portfolio's performance against a representative market index for three years.

Surprisingly, it was found that the losers portfolio consistently beat the market index, while the winners portfolio consistently underperformed. In total, the cumulative difference between the two portfolios was almost 25% during the three-year time span. In other words, it appears that the original "winners" would became "losers", and vice versa.

So what happened? In both the winners and losers portfolios, investors essentially overreacted. In the case of loser stocks, investors overreacted to bad news, driving the stocks' share prices down disproportionately. After some time, investors realized that their pessimism was not entirely justified, and these losers began rebounding as investors came to the conclusion that the stock was underpriced. The exact opposite is true with the winners portfolio: investors eventually realized that their exuberance wasn't totally justified.

According to the availability bias, people tend to heavily weight their decisions toward more recent information, making any new opinion biased toward that latest news.

This happens in real life all the time. For example, suppose you see a car accident along a stretch of road that you regularly drive to work. Chances are, you'll begin driving extra cautiously for the next week or so. Although the road might be no more dangerous than it has ever been, seeing the accident causes you to overreact, but you'll be back to your old driving habits by the following week.

Avoiding Availability Bias
Perhaps the most important lesson to be learned here is to retain a sense of perspective. While it's easy to get caught up in the latest news, short-term approaches don't usually yield the best investment results. If you do a thorough job of researching your investments, you'll better understand the true significance of recent news and will be able to act accordingly. Remember to focus on the long-term picture.


Behavioral Finance: Key Concepts - Prospect Theory
Related Articles
  1. Financial Advisor

    Who is Richard Thaler, Economics Nobel Prize Winner?

    Thaler, one of the founding behavioral economists, won the 2017 Nobel Prize in Economic Sciences.
  2. Trading

    What Is The Crystal Ball Indicator for Traders?

    If you want to be a succesful trader in the market, here we show you the indicators that will help you achieve it long term. Do you have what it takes?
  3. Investing

    The Stock Market: Winners And Losers

    Market contractions - like the one we are currently feeling - produce both winners and losers. Find out which side you are on.
  4. Managing Wealth

    Investing In Crisis, A High Risk-High Reward Strategy

    The financial crisis of 2008 and the great recession that followed is still fresh in the memories of many investors.
  5. Investing

    4 Behavioral Biases And How To Avoid Them

    Here are four common common behavioral biases for traders and how to minimize their effects on your portoflio.
  6. Small Business

    7 Ways Your Emotions Skew Your Business Decisions

    Important decisions such as making a key investment, increasing production or expanding into new lines are all clouded by human emotion. Can you stay cool under pressure?
  7. Trading

    Understanding Investor Behavior

    Discover how some human tendencies can play out in the market, posing the question: are we really rational?
Frequently Asked Questions
  1. How did the ABX index behave during the 2008 subprime mortgage crisis?

    Read about the disastrous performance of the various ABX indexes in the subprime mortgage crisis of 2008 during the middle ...
  2. How did moral hazard contribute to the 2008 financial crisis?

    Learn about moral hazard, how it can affect outcomes and how it contributed to the conditions that led to the 2008 financial ...
  3. Which mutual funds made money in 2008?

    Read about the only mutual fund that turned a profit in 2008. Learn about risk-averse investment strategies and the financial ...
  4. Were Collateralized Debt Obligations (CDO) Responsible for the 2008 Financial Crisis?

    Collateralized debt obligations are exotic financial instruments that can be difficult to understand, Learn the role they ...
Trading Center