What Is an Overreaction in Finance and Investing?

Overreaction is an emotional response to new information. In finance and investing, it is an emotional response to a security like a stock or other investment, which is led either by greed or fear. Investors, overreacting to news, cause the security to become either overbought or oversold, until it returns to its intrinsic value.

Key Takeaways

  • An overreaction in financial markets is when prices become excessively overbought or oversold due to psychological reasons rather than fundamentals.
  • Bubbles and crashes are examples of overreactions to the upside and downside, respectively.
  • The efficient markets hypothesis precludes the occurrence of overreactions, but behavioral finance predicts that they occur - and that smart investors can take advantage of them.

How Overreactions Work

Investors are not always rational. Instead of pricing all publicly known information perfectly and instantly, as the efficient market hypothesis assumes, they are often affected by cognitive and emotional biases.

Some of the most influential work in behavioral finance concerns the initial under-reaction and subsequent overreaction of prices to new information. And many funds now use behavioral finance strategies to exploit these biases in their portfolios, especially in less efficient markets like small-cap stocks.

Funds that seek to take advantage of overreaction, seek out companies whose share prices have been depressed by bad news about their earnings, but where the news is likely to be temporary. Low price-to-book stocks, otherwise known as value stocks, are an example of such stocks.

In contrast to overreaction, under-reaction to new information is more likely to be permanent and is caused by anchoring, a term that describes people's attachment to old information, which is especially strong when that information is critical to a coherent way of explaining the world (also known as a hermeneutic) held by the investor. Anchoring ideas like "brick and mortar retail stores are dead" can cause investors to miss undervalued stocks and opportunities for profit.

Examples of Overreaction

All asset bubbles are examples of overreaction, from the tulip mania in Holland in the 17th century to the meteoric rise of cryptocurrencies in 2017.

Asset bubbles form when the rising price of an asset starts to attract investors as the primary source of return rather than the fundamental returns offered by the asset. For stocks, the "fundamental" return is the growth of the company and possibly the dividend offered by the stock.

The "fundamental return" of a tulip bulb in the 1600s was the beauty of the flower it produced, which is a difficult result to quantify. Because investors didn't have a good way to measure the desirability of the bulbs, price was used as that metric, and because the price of bulbs was always going up, it created the unfounded belief that the bulbs were intrinsically valuable -- and a good investment.

Overreaction to the upside holds until the smart money begins to exit the investment, at which point the value of the security starts to fall producing an overreaction to the downside. In the case of the Dotcom bubble of the late 1990s and early 2000s, the market correction put many unprofitable businesses out of commission, but it also lowered the value of good stocks to bargain levels. Amazon.com Inc. (AMZN) peaked before the Dotcom bubble burst at $86.88 on December 6th, 1999 and fell to its low of $6.98 in September of 2001, a 92.5% loss. Since then the stock has appreciated nearly 5,000%.