The Art Of Overreaction

By Julia Lee

When the sharemarket fluctuates, market players scramble for information to make sense of the market over or underreaction. But did you know that investors tend to put more weight on recent news rather than looking at longer-term information?
Understanding how and why markets overreact can give savvy investors an edge in trading. It provides an opportunity for investors and traders to increase the probability of success when buying into certain stocks.
Recent success stories
Below are some examples of highly fluctuating stocks:
• Gunns saw a low of 26c after its profit downgrade. Since then, the share price has recovered to 63c — a move of 142%.
• Nufarm shares reached a low of $3.20 after its profit downgrade. Since then the share price has recovered to $3.96 — a move of 24%.
• Elders saw a low of 31.5c this year. Since then the share price has recovered to 52.5c — a move of 65%.
This is not about trying to pick the lows in price. What I do want to encourage is that you recognise that market overreaction can present an investment opportunity.
Does the stock market overreact?
Richard Taler & Werner FM De Bondt published a paper back in 1985 titled ‘Does the Stock Market Overreact?’ It found that stocks tend to regress back to the mean.
They also found that when new information comes to the market, market players tend to overweight the new information and underweight old information. In other words, there tends to be a bias towards acting on information from recent developments in a company and discounting old news.
How to profit by waiting for the mean
By keeping a level head while a stock may be getting punished you could have a great opportunity to profit.
If you consider the long-term news along with more recent information, and recognise that eventually the price will regress back to its mean, you’re better off waiting for the stock to form a bottom first before buying.
Of course, recognising the bottom is half the battle.
Check the company’s health
These buying opportunities tend to have binary outcomes. That is, they offer large profits or no profits.
If a company’s share price looks like it’s bottoming out, make sure the company doesn’t fall in the latter category of offering no profits. Always make sure the company is likely to remain solvent. You don’t want the company to file for insolvency or bankruptcy. You want the company to recover and get back on the profit-climbing ladder.
You know what they say: when you are down and out, the only way is up.
Often, if a company continues to make mistakes, it won’t survive. So most companies will try new business strategies, like replacing management, and generally focus on being better at what it does.
Just make sure you do your homework.

Using the Relative Strength Index (RSI)

You can recognise overreaction and under-reaction through technical indicators such as the Relative Strength Index (RSI).
An RSI reading below 30 shows that the market/stock may be oversold and a reading above 70 shows that the market may be overbought.
Make sure you don’t use this technical indicator in isolation. The RSI is prone to many false indications and there’s nothing foolproof in its interpretation. It is absolutely useless during a trend. For example, an up trend causes a continuously overbought indication, while a downtrend pushes it into permanent oversold mode.
On its own, the RSI’s utility is questionable, but when combined with other techniques it really comes into its own.
So make sure you consider the notion of market overreacting.
Happy trading!
Julia Lee
Equities Analyst
Bell Direct

Article Source: http://interpret.zar.vg

About The Author
Julia Lee is an Equities Analyst for online share trading platform Bell Direct. Julia provides information on share trading and online trading for frequent traders and investors.