Does the Stock Market Overreact?

Introduction

This study investigates whether market inefficiency, specifically the violation of Bayes rule, affects stock prices. Research in experimental psychology suggests that most individuals do not follow Bayes rule when making decisions, which could lead to overreaction in the stock market.

Market Efficiency and Bayes Rule

Market efficiency implies that stock prices reflect all available information. Bayes rule is a statistical theorem that describes how to update beliefs in light of new evidence. If investors follow Bayes rule, they should adjust their stock price expectations rationally based on new information.

Overreaction in the Stock Market

However, experimental psychology research suggests that many individuals exhibit cognitive biases, such as confirmation bias and anchoring, which lead them to deviate from Bayes rule. Confirmation bias causes individuals to seek information that supports their existing beliefs, while anchoring bias leads them to rely excessively on initial information.

De Bondt and Thaler's Study (1985)

De Bondt and Thaler conducted a study in 1985 that examined market overreaction by analyzing stock market data. They found evidence suggesting that stock prices tend to overreact to earnings news, with prices initially rising or falling too sharply before gradually returning to their equilibrium levels.

Price Overreactions in the US Stock Market

This paper explores the frequency of price overreactions in the US stock market by focusing on the Dow Jones Industrial Average (DJIA) index. The study analyzes historical data and identifies periods of significant price overreactions, which are often characterized by extreme volatility and irrational investor behavior.

Conclusion

The evidence suggests that market inefficiency and the violation of Bayes rule can lead to overreaction in the stock market. Investors who are aware of these biases and take steps to mitigate their impact can improve their investment decision-making and potentially enhance their returns.