Definition of market over-reaction / market under-reaction

A challenge to the efficient market hypothesis is that individuals often over- or under-react to news.  If over-reactions and under-reactions are split randomly, then these biased reactions could still be consistent with the efficient market hypothesis.

However, psychological factors suggest that there are systematic patterns of over-reaction and under-reaction. For example, individuals tend to be conservative and rely too much on their prior beliefs, and hence they under-react to news. On the other hand, information that is salient and prominent captures people’s attention and becomes more important in the decision making process. People assign a heavier weight to such information in forming new beliefs, resulting in over-reaction. Prices can therefore deviate from their fair or rational market value at least temporarily. 


Some corporate events show post-event return continuation: average subsequent return has the same sign as the event-date stock price reaction. This is usually viewed as evidence of under-reaction to news.

Events that are associated with post-event return continuation include stock splits; tender offer and open market repurchases; equity carveouts; spinoffs; accounting write-offs; analyst earnings forecast revisions; analyst stock recommendations; dividend initiations and omissions; seasoned issues of debt and common stock; public announcement of previous insider trades; and venture capital share distributions. [1]


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