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Overreaction Hypothesis and Contrarian Strategy (the efficiency of financial markets) - Essay Example

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Overreaction Hypothesis and Contrarian Strategy (the efficiency of financial markets)

The OR hypothesis states that investors overreact to information, and that there are two ways by which investors exaggerate their reaction. In the face of bad news, for example, some investors think that the reality is worse and react over-pessimistically, while some think that the reality is not as bad as it seems and react over-optimistically.
So while bad news can be factored in by rational investors according to EMH and their effect on the value of the stock can be calculated before these investors begin to do anything (buy, sell, or hold), some investors are claimed by behavioural finance proponents as acting in irrational ways, making decisions based on their overreaction to information. The effect of overreaction is a large decline in stock prices when pessimistic investors begin to think that the bad news is not true and that the reality is much worse than it really is. The opposite effect holds in the face of good news: investors may overreact and think that the reality is better, so they buy stocks in the market.
This shows that some investors are biased in the way they interpret information, and this bias causes stock price anomalies that can be exploited by investors by using a contrarian strategy. ...Show more

Summary

One of the most basic issues discussed in studies of financial markets is that of its efficiency. Financial market efficiency implies that prices reflect the intrinsic values of the stocks being bought and sold in the market and that the development of the price of a stock over time is a random walk. …
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