Behavioral finance FAQ / Glossary (Over- / Under-react.)

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Dates of related message(s) in the
Behavioral-Finance group (*):

Year/month, d: developed / discussed,
i: incidental

Overreaction / overreact (+ underreaction / underreact)




Seen in many messages, as a
BF classic
+ see reaction,
information,
cascade, Bayesian,
latency, trend, momentum,
weak signal, percolation,
diffusion, status quo, delaying,
cognitive overload + bdef3

Slow motion first, then running, then ballooning,
could not a reaction be more ...reactive?

In financial markets, there is often a whole chain (or we could
say cycle) of investors reactions to crucial news / information / events:

1) In the short term, underreaction,

2) Followed, after a while, by gradual adjustment

3) and, in the long term, by overreaction.

The whole process seems to be the main cause of market trends /

momentum and underpricings / overpricings.

Let us detail those three market phases

Stuck on the old ideas,
then embracing the new ones
then going too far with them.

Phase 1. Investors and analysts under-reaction   
                          (undershooting)

The late investing bird might miss the market worm.

A) Under-reacting investors.


When news / events are signaling an important change of prospects
(for the whole market or for a given stock), investors

* sometimes react impulsively and strongly,

* but more often under-react, not rushing to make a move.

They tend to stay anchored (see anchoring)

on their past analysis,

or at least to hesitate , Hamlet-wise.

Therefore they often

* Either delay (see delaying tactics) their buying or selling decision,

* Or make only small and insufficient initiatives

"Too little, too late".


In markets, the effect is minimal at the beginning, with too
    
small and slow price moves

Well, it gives opportunities to other investors to ride the new
trend before it is exhausted.

Sometimes, they do not react at all. We get a period of lag / latency
with no price changes. Or at least no price trend change, a period of
inertia in which the ship keeps its trajectory.

B) Under-reacting experts and analysts.


In the same way than investors, experts and analysts tend to:

Be frozen / anchored on their past estimates (see
    anchoring),

Therefore, adjust those estimates insufficiently (see

conservatism bias) when a new element alters significantly a
stock prospect.

Do a full adjustment often only after market prices

take the information into account instead of anticipating it.

This frequent lack of adaptation by investors or experts of their judgment
to the new probabilities can be called a non-Bayesian attitude (see Bayes).


The mechanics of under-reaction

There are various reasons why "weak signals", or even strong
signals, are often neglected:

Practical and tactical factors.

Lack / division of attention, all the more when there is
    too many information around (see cognitive overload, noise..),
   
a flood often experienced nowadays.

Lack of appropriate knowledge to appreciate how
    relevant is a new information,

The costs and efforts needed for getting good
    information and processing them.

This can make professionals abler than the general public to
understand new phenomena so as to take advantage of those
factors much earlier.

Or what is considered, maybe wrongly, a prudent
   
attitude waiting for confirmation (see delaying tactics).

Emotional and social factors.

Anchoring on old facts, ingrained beliefs, old estimates,

old heuristics, habits methods, or old explanatory frames.

Also, paradoxically, if a previous decision was made too
early
without waiting for more data, the tendency is to get
anchored
on it (or committed to it), even if new data show
later
otherwise.

Here it is overreaction that is followed by underreaction.

Even more emotional (there is some feeling of pain and 

fear  involved), resistance to change, cognitive 
dissonance, conservatism bias, status quo bias (biases
extensively described in this glossary).

Peer pressure (fear to be wrong alone).


Phase 2. Adjustment

Connecting with reality.

Later on, the information / attitude diffuses inside investor minds and a
gradual price adjustment takes place until the stock reaches its
fundamental value.


Phase 3.
Overreaction

In the end - once the cascade of news and of market reactions fully
confirms the change (see critical threshold) - investors, and above
all non professionals (although manyprofessionals are not immune)
tend to over-react in their euphoria...or fright (see
diffusion, percolation).

Sometimes it even reaches the point in which people think that the
new market behavior shows the new paradigm
valid for all

eternity .

They start to prove it by elaborating totally new "scientific"
explanations to find rationality in the irrational (see rationalization).

The full process,
      as the mother and father of trends?

An explanation of business trends and financial market
momentums (see "trend" and "cycle") is often found in
the overall three step process:

1) Slow start  

2) Acceleration   

3) Breakneck speed.

Instead of sudden disruptions, trends are spread over time, the mispricing
takes time to be corrected ...and to go to the other extreme.

* In bear markets there is a "parachute of hope" that makes the fall
   slow,

* And in a bull market a "wall of worry" that makes the rise take time.

(*) To find those messages: reach that BF group and, once there,
      1) click "messages", 2) enter your query in "search archives".

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This page last update: 23/08/15

 

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