Overreaction Bias
The research described finds that security analysts made forecasts that were too extreme, resembling the overreaction seen in less experienced forecasters. The authors argue that professional status alone does not ensure rational market predictions.
THE IDEA
CONCLUSION
Formal economic models of financial markets typically assume that all agents in the economy are rational. Although most economists recognize that, in fact, not everyone is fully rational, the existence of an irrational segment of the economy is often dismissed as irrelevant with the claim that there will be enough rational arbitrageurs to assure that rational equilibria will still obtain. Whatever the theoretical merits of this position (for a critique, see Russell & Thaler, 1985), an interesting empirical question is whether the presumed smart money segment actually can be identified. This paper investigates one possible source of rationality in financial markets, namely security analysts.
The conclusion we reach from our examination of analysts’ forecasts is that they are decidedly human. The same pattern of overreaction found in the predictions of naive undergraduates is replicated in the predictions of stock market professionals. Forecasted changes are simply too extreme to be considered rational. The fact that the same pattern is observed in economists’ forecasts of changes in exchange rates and macroeconomic variables adds force to the conclusion that generalized overreaction can pervade even the most professional of predictions.
The proper inference from this, we think, is to take seriously the behavioral explanations of anomalous financial market outcomes. When practitioners describe market crashes as panics, produced by investor overreaction, perhaps they are right. After all, are not these practitioners the very same “smart money” that is supposed to keep markets rational?
* The original version of this paper, “Do Security Analysts Overreact?” was published in the American Economic Review, 1990. By permission of the American Economic Association. Although the analyses we report here are the same as those shown in the original, for this book we updated the text and included some references to research that has appeared since our original article appeared.
When to use it
Evaluating the accuracy of stock analyst recommendations and adjusting for potential overreaction.
Forecasting economic variables such as GDP growth or inflation, where overreaction to news may lead to errors.
Analyzing market reactions to corporate earnings announcements to identify overreaction patterns.
Designing quantitative models that account for behavioral biases in financial markets.
FROM THEORY TO EVERYDAY LIFE
In practice
Analyst Earnings Forecasts
In the research described, security analysts forecast earnings changes that were too extreme. The authors interpret this pattern as overreaction, comparable to errors found in inexperienced forecasters.
Exchange Rate Predictions
The authors also report overreaction in economists’ forecasts of exchange rates and macroeconomic variables. They use that evidence to question whether professional forecasters reliably correct such errors.
A MOMENT TO REFLECT
Put it to work.
How might the overreaction bias affect your own investment decisions or professional forecasts?
Can you recall a situation where a market panic or overreaction occurred, and what were the consequences?
What methods could be used to mitigate overreaction in financial or economic predictions?
Often confused with
References
- Do Security Analysts Overreact? — De Bondt and Thaler (1990)
- A Critique of Rational Arbitrage — Russell and Thaler (1985)
CONTINUE THE CONVERSATION
Source texts
- Heuristics and Biases The Psychology of Intuitive Judgment (Thomas Gilovich, Dale Griffin, Daniel Kahneman)