The overreactions and availability bias of traders

overreaction of traders

One of the consequences of traders' emotions when trading is an overreaction to new information. Depending on the market's efficiency, any new information is likely more or less immediately reflected in the price of an asset. For example, good news will likely increase the value of a company and therefore the price of its stock, while the price of a stock will not decrease if there's no new information.

However, reality tends to contradict this theory. Often, market participants display excessive reactions to new information, creating a bigger movement on the price of a stock. It also seems that this price surge isn't a permanent phenomenon - although the price change is usually sudden and significant, the rise will erode over time.


Winners and losers

In 1986, behavioural finance academics Werner Debond and Thaler Richard published a study on NYSE returns over a 3-year period. They split up the top 34 stocks into a "winners portfolio" and the worse 34 stocks into a "losers portfolio". Bond and Thaler then tracked the performance of each portfolio against a representative market index for 3 years.

Surprisingly, it was found that the losers' portfolio consistently beat the market index, while the winners' portfolio consistently underperformed the market. At the end, the cumulative gap between the two portfolios was nearly 25% over the 3 years. In other words, it seems that the original "winners" would became "losers" and vice versa.

What happened? In both stock portfolios, investors overreacted. In the case of the losing stocks, investors overreacted to bad news, resulting in a disproportionate fall in stock prices. After a while, they realised that their pessimism wasn't entirely justified and that the stocks were undervalued, so these losing stocks began to rebound. The opposite occurred with the winners' portfolio: investors finally realised that their exuberance wasn't fully justified.

According to availability bias, people tend to assign extra weight to their decisions when they have recent information, thus biasing their new opinions because of recent news.

It happens all the time in real life. For example, suppose you see a car accident along a road that you often use to get to work. As a result, you will probably start driving more carefully the following week. Although the road is no more dangerous than before, the accident caused you to overreact, but your old driving habits will resume the following week.


Avoiding availability bias

The most important lesson you should get here is that you need to keep a sense of perspective. It's easy to get caught up in the latest news, and short-term approaches usually don't produce the best investment results. If you perform thorough research, you will better understand the true meaning of the latest news and react accordingly. Remember to focus on the long-term scheme of things.

Contents - behavioural finance theory