Overreaction
Candlefocus EditorOverreaction in financial markets, also known as “overshooting” or “excess volatility”, is a phenomenon where the price of a security becomes far greater or far lower than its fundamentals values due to investor’s emotional reactions, rather than driven by analysis and rational evaluations.
Overreactions usually come in two forms — an overreaction to the upside and a overreaction to the downside. An example of an overreaction to the upside is the “dot-com bubble” in the late 1990s. During the height of the tech stocks boom, many tech companies were overvalued due to speculation and exaggerated enthusiasm. On the other hand, an example of an overreaction to the downside is the “credit crunch” of 2008, when financial institutions went bankrupt as a result of bad investments, plummeting home prices and lack of liquidity in the market.
The efficient markets hypothesis, which posits that all financial assets are perfectly priced based on current market conditions and any deviations from equilibrium levels will be short-lived, predicts that overreactions don’t happen. However, according to behavioral finance, overreactions do occur, and smart investors can take advantage of the opportunity.
Savvy investors can realize profits by identifying when the market has overreacted to the upside or the downside and buying or selling at an advantageous point. A trader watching a stock that has doubled in price in a short period of time, for example, may be able to recognize that the price is far higher than the stock’s fundamental value and will eventually come back down. In such cases, they may choose to sell the stock at the inflated price, realizing a profit.
In conclusion, overreactions in financial markets can provide opportunities for savvy investors to realize quick profits by understanding the market’s tendency to move further than its fundamentals suggest from time to time. The efficient markets hypothesis does not allow for overreactions, but according to behavioral finance, investors can take advantage of this phenomenon.