Does The Stock Market Overreact?

To understand whether a mechanical trading system could work, it might be useful to understand a little more about the answer to this question...

In days gone by, and a land far far away, investors used to believe that the market did 'overshoot'. This belief was built more on instinct and personal observation than any research or specific analysis.

In part, this instinct was due to Dow Theory and Ralph Elliott's Wave Theory (now known as Elliott Wave Theory (information here)). Which had both held significant intellectual promience in the markets. It ought to be added that the results of Ben Graham and his value investing (information here) approach would seem to add to this. Though Graham's method bought troubled companies whose stock values would typically remain depressed for long periods of time, partly because the underlying business was in trouble.

That was all until December 1985.

A paper presented to the annual meeting of the American Finance Association sought to address this question. In short, the analysis of it's authors - Thaler and DeBondt - was that YES (!) stock markets do indeed overreact.

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They demonstrated how new information about a stock or market was taken into account and given too much weight when compared to all the information that had passed before. This extra weight clouded the judgement of otherwise rational investors.

They concluded that this makes stock prices overshoot - in both directions - to such a regular degree that the overshoot and size of overshoot can be predictable. Then in time, these prices would 'regress to the mean' which is a technical way of saying that prices will generally move back to the average.

This might not have been a new theory, and many academics argued over the findings of the paper, but it did lay out in a researched way something which had only been guessed at previously.

This may lead an investor to believe that a stock prediction system which looks for technical triggers that a stock is overbought or oversold can and should be profitable. That investor would be right!

It would appear that in the years just before and after the 2000, that a phenomenon of overreaction was obvious to everyone. The bull market of the late 1990's that helped high-tech, media and online firms to race ahead was barely led by sanity. An overreaction?

The following house price boom in the United States, United Kingdom, the Netherlands, Spain and others was equally forceful. Prices had been rising so strongly, for so long, that lots of people were joining the party, investing at the last minute, hoping to get their share of the pie. They were too late.

One explanation that your author thinks may hold true is that of reflexivity. This is a theory first offered by the legendary hedge fund manager George Soros which suggests that as market prices change, the activity of those involved in the markets change too. As their activity changes, they impact prices further. (In other words, the more of a stock you buy, the greater the impact on price will be had, bringing more buyers in, impacting the price further).

Of course, it could also be said more simply that markets overreact because of the simple competing human emotions of fear and greed and our amazing ability to act in an almost lemming like fashion at times!

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This tendency to be blinded by greed and to panic in a crisis is part of what makes us human and markets markets. The first known example of this was the 'Tulip Mania' in the Netherlands. Since then, expansions have lead to booms and booms have lead to busts. Each is an example of the market behaving wildly.

However, it is at the depths of despair and the wild highs of the boom that the trend is likely to continue for too long. It is at these points that the last private investors are forced out or sucked into the stock market that the overreaction in prices is likely to occur.

This is a phenomenon that Galbraith writes about in The Great Crash 1929 (information here), that as people watched prices fall they would eventually believe that they could fall no further, tempting then in to the market. Of course, prices did fall much further, ruining a great many more people than might otherwise have been the case. Whether this relates entirely to greed, or is in part jealousy (seeing everyone else make easy money), who can say? It does seem, however, to be a key area of the psychology of financial markets.

Who makes the decisions?

Additionally, many funds are now operated by complex algorithm. These are not the high frequency trading funds (though they are run by algorithm) but normal index tracker type funds. It is widely believed that the sell off and brief Wall Street panic of 1987 was due in large part to insurance limits set to sell at pre-arranged prices. While this makes sense intellectually, the result was that lots of funds did exactly the same thing at an identical time! That must be definition of a stock market overreacting.

These algorithms have been toned down now and many lessons have been learned, but there is still a complex relationship between the competing powers of human psychology and computer based fund management.

Other pages which may be of interest include:

Are You An Irrational Investor?

How To Find Great Stock Trading Courses

Stock Trading For Beginners

Why Use Stock Market Programs?

Should You Be Investing In Stock Market Assets?

Does Automated Stock Trading Software Work?

Why Do So Many Stock Market Traders Go Broke?