what is an overreaction 
an overreaction is an extreme emotional response to new information in finance and investing it is an emotional response to a security such as a stock or other investment which is led either by greed or fear investors overreacting to news cause the security to become either overbought or oversold until it returns to its intrinsic value understanding overreactionsinvestors are not always rational many investors base buy and sell actions on emotional behavior at times easy access to 24 hour information and news can cause unwarranted investor actions instead of pricing all publicly known information perfectly and instantly as the efficient market hypothesis assumes they are often affected by cognitive and emotional biases some of the most influential work in behavioral finance concerns the initial underreaction and subsequent overreaction of prices to new information many funds now use behavioral finance strategies to exploit these biases in their portfolios especially in less efficient markets such as small cap stocks funds that seek to take advantage of overreactions look for companies whose shares have been depressed by bad earnings news but where the news is likely to be temporary low price to book stocks otherwise known as value stocks are an example of such stocks in contrast to overreaction underreaction to new information is more likely to be permanent an underreaction is often caused by anchoring a term that describes people s attachment to old information which is especially strong when that information is critical to a coherent way of explaining the world also known as a hermeneutic held by the investor anchoring ideas such as brick and mortar retail stores are dead can cause investors to overlook undervalued stocks and miss opportunities to make a profit examples of overreactionall asset bubbles are examples of overreaction from the tulip mania in holland in the 17th century to the meteoric rise of cryptocurrencies in 2017 asset bubbles form when the rising price of an asset starts to attract investors as the primary source of return rather than the fundamental returns offered by the asset for stocks the fundamental return is the growth of the company and possibly the dividend offered by the stock the fundamental return of a tulip bulb in the 1600s was the beauty of the flower it produced which is a difficult result to quantify because investors didn t have a good way to measure the desirability of the bulbs price was used as that metric and because the price of bulbs was always going up it created the unfounded belief that the bulbs were intrinsically valuable and a good investment overreaction to the upside holds until the smart money begins to exit the investment at which point the value of the security starts to fall producing an overreaction to the downside in the case of the dotcom bubble of the late 1990s and early 2000s the market correction put many unprofitable businesses out of commission but also lowered the value of good stocks to bargain levels amazon com inc peaked before the dotcom bubble burst at 106 70 on dec 10 1999 before falling to a low of 5 97 in september of 2001 a 94 loss in 2020 the average stock price of amazon was 2 680 86 1