Behavioral Finance: Key Concepts - Overreaction and Availability

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.

Sumber: http://www.investopedia.com

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

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-            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.

Size Effect

The size effect, also called the small cap effect, is the tendency of small cap shares to outperform large caps over the long term. Evidence for this looks less good than it once did.

The size effect can be explained by the illiquidity of small companies, particularly as a result of higher trading costs (e.g., because of higher spreads).

The extent of the small cap effect has varied over time, with quite long periods of over-performance and under-performance compared to large caps, which makes it difficult to assemble enough data to provide a definitive proof or disproof.

Given that the biggest weakness strategies using the small cap effect is that the real out-performance is likely to be offset by trading costs, perhaps the best advice to investors is to regard it as most relevant when constructing a portfolio of shares that they are likely to hold for the long term. (http://moneyterms.co.uk/size-effect/)

Stock Markets and The Size Effect

There's real value in understanding market capitalization!

Large-cap, small-cap and mid-cap stocks all perform differently, and their sizes change. That's why you need to follow market capitalization -- the total value the stock market places on a company.

Market capitalization refers to the total value the market puts on a company. It's calculated by multiplying the price of a stock by its total number of shares.

So the concept of market capitalization is straightforward and pretty simple to grasp. The reason you want to know about it is that different sized companies perform differently. The details of how that happens, though, are not so clear.

Many studies have shown that small firms (capitalization or assets) tend to outperform large ones. Other studies have argued that it is not the size that matters, but it is the attention and number of analysts that follow the stock.

Anyway, "The Size Effect" is subject to intense debate over whether an opportunity to generate excess returns actually exists, or that its not reasonable to assume that investors can realize those returns.

Small stocks typically have large spreads, thus providing large trading opportunities. On the other hand, it is not easy to be bought by institutional managers without significantly affecting the share price.

Therefore, even so called "small company" funds have difficulty taking advantage of small capitalization stocks. The point being that you couldn't really buy them in large quantities, if at all, at their quoted price.

More comprehensively on introduction about size effect, please download this paper:

A history of the size effect

RD Coleman - 1997 - numeraire.com
31 October 1997

First Submitted: 13 June 1995

Current Draft: 31 October

A Critique of Size-Related Anomalies

by JB Berk - 1995 

Important Papers

1.          BERK, J.B., 1995. A critique of size-related anomalies. Review of Financial Studies. 

2.         KNEZ, P.J. and M.J. READY, 1997. On the robustness of size and book-to-market in crosssectional regressions. Journal of Finance. 

3.         LAMOUREUX, C.G. and G.C. SANGER, 1989. Firm size and turn-of-the-year effects in the OTC/NASDAQ market. Journal of Finance. 

4.         HERRERA, M.J. and L.J. LOCKWOOD, 1994. The size effect in the Mexican stock market. J. BANKING FINANCE. 

-            Capital Markets and Informational Efficiency

-            ACEMOGLU, D. and M.P. PAGE, 2000. Technical change, inequality, and the labor market.

-            ACEMOGLU, D., J. LINN and M.P. PAGE, 2003. Market size in innovation: theory and evidence from the pharmaceutical industry.

-            ALESINA, A., R. WACZIARG and M.P. PAGE, 1998. Openness, country size and government. Journal of Public Economics. 

-            ANDERSON, Don, Andrea HAYNES and Richard HEANEY, Company Takeovers and Equity Returns: The Target Size Effect

-            BARRY, C.B., et al., 2002. Robustness of size and value effects in emerging equity markets, 1985-2000. Emerging Markets Review. 

-            BERK, J.B., 1995. A critique of size-related anomalies. Review of Financial Studies. 

-            BERNARD, V., J. THOMAS and J. WAHLEN, 1997. Accounting-based stock price anomalies: Separating market inefficiencies from risk. Contemporary Accounting Research. 

-            BRACONIER, H. and K. EKHOLM, 2002. Competition for Multinational Activity in Europe: The Role Played by Wages and Market Size.

-            CARHART, Mark M., Leaning for the Tape: Evidence of Gaming Behavior In Equity Mutual Funds

-            CHOI, J.P. and M. THUM, 1997. Market structure and the timing of technology adoption with network externalities.

-            COLEMAN, R. D., 1997. http://www.numeraire.com/download/history.pdf

-            COLWELL, P.F. and H.Y. PARK, 1990. Seasonality and size effects: The case of real-estate-related investment. The Journal of Real Estate Finance and Economics. 

-            DAMODARAN, A., 1989. The weekend effect in information releases: a study of earnings and dividend announcements. Review of Financial Studies. 

-            DANIEL, Kent and Sheridan TITMAN, Evidence on the Characteristics of Cross Sectional Variation in Stock Returns

-            DAVIS, James, Eugene F. FAMA, and Kenneth R. FRENCH, Characteristics, Covariances, and Average Returns: 1929-1997

-            De GIORGI, Enrico, Thorsten HENS and Thierry POST, 2005. Prospect Theory and the Size and Value Premium Puzzles

-            EGGERT, W. and M. KOLMAR, 2004. Contests with Size Effects.

-            FAMA, E.F. and K.R. FRENCH, 1998. Market efficiency, long-term returns, and behavioral finance. Journal of Financial Economics. 

-            FAMA, Eugene F. and Kenneth R. FRENCH, Permanent and Temporary Components of Stock Prices

-            FRANKEL, R. and C.M.C. LEE, 1998. Accounting valuation, market expectation, and cross-sectional stock returns. Journal of Accounting and Economics. 

-            GLOSTEN, L.R. and P.R. MILGROM, 1984. Bid, ask and transaction prices in a specialist market with heterogeneously informed traders.

-            GUTIERREZ, R., 2001. Book-to-market equity, size, and the segmentation of the stock and bond markets.

-            HALL, B.H., 1986. The relationship between firm size and firm growth in the US manufacturing center.

-            HERRERA, M.J. and L.J. LOCKWOOD, 1994. The size effect in the Mexican stock market. J. BANKING FINANCE. 

-            HONG, Harrison, Terence LIM and Jeremy C. STEIN, Bad News Travels Slowly: Size, Analyst Coverage, and the Profitability of Momentum Strategies

-            JAGANNATHAN, R., K. KUBOTA and H. TAKEHARA, 1998. … Between Labor-Income Risk and Average Return: Empirical Evidence from the Japanese Stock Market. Journal of Business.

-            JAUMOTTE, F., 2004. Foreign direct investment and regional trade agreements: the market size effect revisited.

-            JEGADEESH, N., 1992. Does market risk really explain the size effect. Journal of Financial and Quantitative Analysis. 

-            JEGADEESH, Narasimhan, Does Market Risk Really Explain the Size Effect?

-            KANG, J.K. and R. STULZ, 1997. Why is there a home bias. An analysis of foreign portfolio equity. 

-            KEIM, D.B. and A. MADHAVAN, 1996. The upstairs market for large-block transactions: analysis and measurement of price effects. Review of Financial Studies. 

-            KNEZ, P.J. and M.J. READY, 1997. On the robustness of size and book-to-market in crosssectional regressions. Journal of Finance. 

-            KONINGS, J., H. LEHMANN and M.E. SCHAFFER, 1996. Job creation and job destruction in a transition economy: ownership, firm size, and gross job flows ….

-            KRASHINSKY, H., 2002. Evidence on Adverse Selection and Establishment Size In the Labor Market.. Industrial and Labor Relations Review 56 (1): 84. 

-            LAMOUREUX, C.G. and G.C. SANGER, 1989. Firm size and turn-of-the-year effects in the OTC/NASDAQ market. Journal of Finance. 

-            LOUGHRAN, T. and J.R. RITTER, 2000. Uniformly least powerful tests of market efficiency. Journal of Financial Economics. 

-            MALKIEL, B.G., 2003. The Efficient Market Hypothesis and Its Critics. Journal of Economic Perspectives. 

-            MARTIN, P.J. and H. REY, 2001. Financial super-markets: size matters for asset trade.

-            MELITZ, M. and G.I.P. OTTAVIANO, 2003. Market Size, Trade, and Productivity. Harvard University, mimeograph. 

-            MERTON, R.C. and C. ROBERT, 1987. A simple model of capital market equilibrium with incomplete information. Journal of Finance. 

-            MITCHELL, W., 1991. Dual clocks: Entry order influences on incumbent and newcomer market share and survival when …. Strategic Management Journal. 

-            PODOLNY, J.M., 2001. Networks as the Pipes and Prisms of the Market. American Journal of Sociology. 

-            RAEDY, J., 2000. A reconciliation of stock market anomalies.

-            REINGANUM, Marc R., A Direct Test of Roll's Conjecture on the Firm Size Effect

-            SCHWERT, G.W. and M.P. PAGE, 2002. Anomalies and market efficiency.

-            SKERRATT, Len, Contrarian investment strategies using financial ratios

-            VLIET, W. N. van, 'Investment Strategies and Real Option Theory'

-            WIGNARAJA, G., 2002. Firm Size, Technological Capabilities and Market-oriented Policies in Mauritius. Oxford Development Studies. 

-            WINTER-EBMER, R. and J. ZWEIMUELLER, 1999. Firm Size Wage Differentials in Switzerland: Evidence from Job Changers. American Economic Review (Papers and Proceedings). 

-            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.