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.
Other Quatation and Journal About Overreaction
"...investors overreact to negative news."
Shefrin (2000)
"De Bondt and Thaler argued that investors overreact to both bad news and good news. Therefore, overreaction leads past losers to become underpriced and past winners to become overpriced."
Shefrin (2000)
"De Bondt and Thaler predicted overreaction based on representativeness. [...] a portfolio of extreme losers does outperform the market. However, a careful inspection of the figure shows that the effect is concentrated in the month of January."
Shefrin (2000) page 42
"Fama (1998a, 1998b) argues that "apparent overreaction of stock prices to information is about as common as underreaction."
Shefrin (2000) page 87
"Rather, what we find is apparent underreaction at short horizons and apparent overreaction at long horizons."
Shefrin (2000) page 87
"What we seem to have is overreaction at very short horizons, say less than one month (Lehmann, 1990), momentum possibly due to underreaction for horizons between three and twelve months (Jegadeesh and Titman 1993) and overreaction for periods longer than one year (De Bondt and Thaler 1985, 1987, 1990)."
Shefrin (2000) page 85
"The overreaction evidence shows that over longer horizons of perhaps three to five years, security prices overreact to consistent patterns of news pointing in the same direction."
Shleifer (2000) page 112
- ABARBANELL, Jeffry S. and Victor L. BERNARD, 1992. Tests of Analysts' Overreaction/Underreaction to Earnings Information as an Explanation for Anomalous Stock Price Behavior
- AIYAGARI, S. Rao and Mark GERTLER, 1999. ��Overreaction�� of Asset Prices in General Equilibrium
- ANTONIOU, Antonios, Emilios C. GALARIOTIS, and Spyros I. SPYROU, 2001. Contrarian Profits and the Overreaction Hypothesis: The Case of the Athens Stock Exchange
- BARBERIS, Nicholas, Andrei SHLEIFER and Robert VISHNY, 1998. A Model of Investor Sentiment
- BARBERIS, Nicholas, Andrei SHLEIFER and Robert VISHNY, 1998. A model of investor sentiment
- BAYTAS, Ahmet and Nusret CAKICI, 1999. Do markets overreact: International evidence
- BERNSTEIN, Peter L., 1985. Does the Stock Market Overreact?: Discussion
- BOWMAN, Robert G. and David IVERSON, 1998. Short-run overreaction in the New Zealand stock market
- CAGINALP, Gunduz, David PORTER and Vernon SMITH, 2000. Momentum and overreaction in experimental asset markets
- CONRAD, Jennifer and Gautam KAUL, 1993. Long-Term Market Overreaction or Biases in Computed Returns?
- De BONDT, Werner F. M. and Richard H. THALER, 1987. Further Evidence on Investor Overreaction and Stock Market Seasonality
- De BONDT, Werner F. M. and Richard H. THALER, 1990. Do Security Analysts Overreact? [about 168]
- De BONDT, Werner F. M. and Richard THALER, 1985. Does the Stock Market Overreact?
- DIACOGIANNIS, G.P., et al., 2005. Price limits and overreaction in the Athens stock exchange. Applied Financial Economics.
- DREMAN, David N. and Eric A. LUFKIN, 2000. Investor overreaction: Evidence that its basis is psychological, The Journal of Psychology and Financial Markets, Vol. 1, No. 1, 61-75.
- FAMA, Eugene F., 1998. Market efficiency, long-term returns, and behavioral finance
- FULLER, Russell J., 2000. Behavioral Finance and the Sources of Alpha
- GAUNT, Clive, 2000. Overreaction in the Australian equity market: 1974-1997
- HONG, Harrison and Jeremy C. STEIN, 1997. A Unified Theory of Underreaction, Momentum Trading and Overreaction in Asset Markets
- HONG, Harrison and Jeremy C. STEIN, 1999. A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets
- JEGADEESH, Narasimhan and Sheridan TITMAN, 1993. Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency
- JEGADEESH, Narasimhan and Sheridan TITMAN, 1995. Overreaction, Delayed Reaction, and Contrarian Profits
- JOHNSSON, Malena, Henrik LINDBLOM and Peter PLATAN, 2002. Behavioral Finance - And the Change of Investor Behavior during and After the Speculative Bubble At the End of the 1990s
- LARSON, Stephen J. and Jeff MADURA, 2001. Overreaction and underreaction in the foreign exchange market, Global Finance Journal 12 (2001) 153-177
- LEHMANN, Bruce N., 1993. Fads, Martingales, and Market Efficiency
- LO, Andrew W. and A. Craig MacKINLAY, 1990. When are Contrarian Profits Due to Stock Market Overreaction?
- LOUGHRAN, Tim and Jay R. RITTER, 1996. Long-Term Market Overreaction: The Effect of Low-Priced Stocks, Journal of Finance, Volume 51, Issue 5 (Dec., 1996), 1959-1970.
- MASSEY, C. and G. WU, 2005. Detecting regime shifts: The psychology of under-and overreaction. Management Science.
- MICHAELY, Roni, Richard H. THALER and Kent L. WOMACK, 1995. Price Reactions to Dividend Initiations and Omissions: Overreaction or Drift?
- MUN, Johnathan C., Geraldo M. VASCONCELLOS and Richard KISH, 2000. The Contrarian/Overreaction Hypothesis An analysis of the US and Canadian stock markets
- NAM, Kiseok, Chong Soo PYUN and Stephen L. AVARD, 2001. Asymmetric reverting behavior of short-horizon stock returns: An evidence of stock market overreaction
- OFFERMAN and SONNEMANS, 2000. What's Causing Overreaction? An Experimental Investigation of Recency and the Hot Hand Effect
- POTESHMAN, 2000. Underreaction, Overreaction, and Increasing Misreaction to Information in the Options Market
- POWER, D. M. and A. A. LONIE, 1993. The Overreaction Effect: Anomaly of the 1980s?
- RATNER and LEAL, 1998. Evidence of Short-Term Price Reversals Following Large One Day Movements in the Emerging Markets of Latin America and Asia
- SEYHUN, 1990. Overreaction or Fundamentals: Some Lessons from Insiders' Response to the Market Crash of 1987
- SHEFRIN,
- Hersh, 2000. Beyond Greed and Fear : Understanding Behavioral Finance and the Psychology of Investing.
- SKERRATT, 2000. Behavioural explanations for under and overreaction
- SKERRATT, 2000. Are analysts responsible for post earnings announcement drift and other anomalies that suggest that the market generally adjusts inadequately to new information?
- SKERRATT, 2000. Do analysts overreact to information?
- THEOBALD, Michael and Peter YALLUP, Determining security speed of adjustment coefficients
- VERONESI 1999. Stock Market Overreaction to Bad News in Good Times: A Rational Expectations Equilibrium Model
- WANG, J., et al., 2004. Analysis of the overreaction effect in the Chinese stock market. Applied Economics Letters.
- XIANG, HE and CAO, 2002. Continuous overreaction, insiders trading activities and momentum strategies
- ZAROWIN, Paul, 1990 Size, Seasonality, and Stock Market Overreaction, The Journal of Financial and Quantitative Analysis, Vol. 25, No. 1. (Mar., 1990), pp. 113-125.
No comments:
Post a Comment