Rooted in investor psychology, the overreaction hypothesis contends that investors suffer from cognitive biases that affect their trading activities and, consequently, stock prices.
The authors postulated the overreaction hypothesis based on the findings of an experimental study in psychology conducted by Kahneman and Tversky , wherein individuals were found to initially overreact to the arrival of unexpected news.
Further, if the market overreacts only to intangible information, it also seems reasonable to identify stocks as winners and losers based on intangible returns, rather than total returns (TR), to test the overreaction hypothesis of long-term return reversals.
1) Evidence in support of the overreaction hypothesis of reversals has been documented in Chopra, Lakonishok, and Ritter (1992) and Lakonishok, Shleifer, and Vishny (1994).
TABLE 5 Summary Statistics of Variables Used for Overreaction Hypothesis
Testing Variable Definition OVER Estimated overreaction 1.
This finding supports the overreaction hypothesis and sets grounds for contrarian portfolio strategies.
Whatever the factors of predictability, it has been recently established that the asymmetric effect of a change in volatility on mean-reverting behaviors of short horizon equity returns can be explained by the overreaction hypothesis.
The overreaction hypothesis cannot fully explain our results, however, as forced selling pressure, which is not associated with the release of public information, is both statistically and economically significant by itself after controlling for returns.
We present the most commonly examined explanations of firm repurchase behavior: the free cash flow hypothesis, the overreaction hypothesis, the signaling/undervaluation hypothesis, and the liquidity provision hypothesis, as well as several secondary considerations.
The overreaction hypothesis is consistent with the notion that prices can move beyond equilibrium values, but will eventually reverse themselves as traders sort through the information.
The overreaction hypothesis asserts that price and volatility are affected by trading noise.
The Overreaction Hypothesis
(OH) explains these inefficiencies by predicting that prices will be undervalued preceding unfavorable announcements.