Overreaction hypothesis

Overreaction hypothesis

The supposition that investors overreact to unanticipated news, resulting in exaggerated movements in stock prices followed by corrections.

Overreaction Hypothesis

A theory stating that the crowd overreacts to both good news and bad news. For example, when a company announces unexpectedly high earnings, this can create a buying panic that unjustifiably drives up the company's stock price. Likewise, when the earnings are unexpectedly bad, there can be a selling panic that drives down the price. One can use the overreaction hypothesis to make short-term profits in either direction.
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2016); Ng and Wu (2007) and Wu (2011) also find that the pure contrarian strategy can, in the Chinese stock market, produce positive excess return, and a strategy combining mean reversion and momentum can outperform a buy-and-hold strategy, which collectively supports the overreaction hypothesis.
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 [13], wherein individuals were found to initially overreact to the arrival of unexpected news.
TABLE 5 Summary Statistics of Variables Used for Overreaction Hypothesis Testing Variable Definition OVER Estimated overreaction 1.
Theories that support the relationship between pre-IPO operating performances, IPO's underpricing, and long run performances include the changing-risk composition hypothesis (Ritter, 1984) and the overreaction hypothesis (Daniel, Hirshleifer, & Subrahmanyam, 1998).
They tested the overreaction hypothesis in the 6 months after IPO with a sample of 301 high-tech IPOs, and found that momentum variables were important to explain the firm's medium-term performance, which is consistent with the overreaction prediction.
This finding supports the overreaction hypothesis and sets grounds for contrarian portfolio strategies.
Liang and Mullineaux (1994) test stock price behavior before and after surprise events and find evidence consistent with the overreaction hypothesis but inconsistent with the uncertain-information hypothesis.
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.
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 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.
The Overreaction Hypothesis (OH) explains these inefficiencies by predicting that prices will be undervalued preceding unfavorable announcements.