Behavioral finance, use social, cognitive and emotional factors in understanding theeconomic decisions of individuals and institutions performing economic functions,including consumers, borrowers and investors, and their effects on market prices, returnsand the resource allocation. For this application report I have chosen to understand twowidespread phenomenon of over-reaction and under-reaction in stock market through the prospective of behavioral decision-making.
2. Behavioral phenomenon
Stock markets are often time govern by sentiments rather than underlying fundamentals.This often leads to irregularities that cannot be explained from rational prospective. The pervasive irregularities are under-reaction and over-reaction.
- Under-reaction is a phenomenon where the good news such as goodearning news, share buybacks or dividend payouts are slowly incorporated into the stock price. As a result the stock price does not truly reflect the price of the stock. A relatedway to look this point is to argue that current good news has power in predicting positivereturns in the future. As per research from behavioral scientists shows that over thehorizons of perhaps one to twelve months, security prices under-react to good news.
- Over-reaction is a phenomenon where the stocks get over-priced after they had a long record of good news. Put differently, securities with strings of good performance received extremely high valuations and these valuations. These highvaluations suggest that future returns will be low. This also works the other way i.e., thestocks get cheap after series of bad news such as negative earning surprises.
3. Explanation of Phenomenon - Cognition Prospective
The human judgment process is governed by heuristics and biases under uncertainty.From the physiological
prospective, there are certain biases that can explain the under-reaction and over-reaction.