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 Nathan Reiff

The concept of market efficiency assumes that new information about a security will be reflected more or less instantaneously in the price of that security in the market. Good news about a company should increase the business’ share price a proportional amount, and that price should then remain steady until new information about the company becomes available.

In reality, though, this idealized expectation rarely comes to pass in such a clean, unimpeded fashion. Often, participants in the stock market actually overreact to new information, thereby creating an impact on the price of a security which is larger than it should be relative to the scope of the information. Additionally, the price surge which customarily accompanies good news is not a permanent trend; rather, it tends to erode over time, even if no new information has been introduced.

Winners and Losers

Behavioral finance theorists Werner De Bondt and Richard Thaler released a 1985 study in the Journal of Finance called “Does the Market Overreact?” In their paper, the two researchers explored the returns on the New York Stock Exchange over a three-year period. From the stocks they analyzed, De Bondt and Thaler separated out the 35 top performing stocks into a “winners portfolio” and the 35 lowest performing stocks into a “losers portfolio.” The study tracked each portfolio’s performance as compared with a representative market index over three years.

As it turns out, the losers portfolio actually beat the market index consistently. On the other hand, the winners portfolio consistently underperformed the market. Over the three-year period, the cumulative difference between the two portfolios was nearly 25%; put differently, the original “winners” tended to become “losers,” and vice versa.

Why did this happen? In the case of both winning and losing stocks, investors tended to overreact. For losing stocks, investors overreacted to negative news, thereby driving the stocks’ share prices down artificially and disproportionately. Over time, though, it became clear that this pessimism was outsized, and the losing stocks actually began to rebound as investors realized that the stocks were underpriced. The same is true in reverse for the winners portfolio, as investors eventually understood that their initial enthusiasm was overblown.

Part of the reason for this overreaction has to do with the availability bias. According to this bias, people tend to weigh their decisions more heavily toward recent information. New opinions thus become biased toward the latest news. (For more, see How Cognitive Bias Affects Your Business)

Availability bias can creep into our lives in subtle ways as well as significant ones. For example, imagine that you see a car accident along a stretch of road that you drive on regularly during your commute to work. It’s likely that you’ll be more cautious on that stretch of road, at least for a few days after the accident. You may be inclined to behave in this way even if the level of danger on the road has not changed at all; seeing the accident caused you to overreact. However, over time, it’s likely that you’ll regress to your previous driving habits.

Avoiding Availability Bias

We are all subject to availability bias and overreaction in various ways, and it can be difficult to keep those things in check. One of the ways to do so, however, is to work on retaining a sense of perspective over the long term. It can be easy to get caught up in the latest news, but short-term investment approaches rarely yield the best results. You are likely better served by thoroughly researching your investments so that you can accurately assess the impact of the daily news cycle without being likely to overreact in the short term.

Behavioral Finance: Key Concepts - Prospect Theory
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