Behavioral finance FAQ / Glossary (Over- / Under-react.)
This is a separate page of the N-O and T-U sections of the Glossary
Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
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
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
Therefore, adjust those estimates insufficiently (see
conservatism bias) when a new element alters significantly a
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
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
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
Sometimes it even reaches the point in which people think that the
new market behavior shows the new paradigm valid for all
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
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
* 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".
Members of the BF Group, please
vote on the glossary quality at BF polls
This page last update: 23/08/15