An Overview Of Under-reaction And Over-reaction

In recent years, behavior finance is capturing more and more attention in the hot field of finance, and one of the hotspots in behavior finance is under-reaction and over-reaction. Because of the existence of under-reaction and over-reaction , the security market is to some extent predictable. And the predictability reflects especially the fact that security return takes on positively auto-correlated in short term while negatively auto-correlated in long term. Based on short-term positive auto-correlation, the momentum investment strategy that buys previous winners and sells previous losers can be derived. Based on long-horizon negtive auto-correlation,the contrarian investment strategy that buys previous losers and sells previous winners can be devised. These strategies are verified to yield significant profits.The thesis expatiates contents about under-reaction and over-reaction. Firstly, we discuss about the efficient market hypothesis, and the challenge that EMH is facing. Then we analyze heuristics and biases in judgment under uncertainty, which provides explanations for under-reaction and over-reaction. Furthermore, We introduce three formal models to explain under-reaction and over-reaction, and give these models further discussion. After explaining under-reaction and over-reaction, we study corresponding investment strategies: momentum investment strategy and contrarian investment strategy. Many studies have already proved these strategies efficient.Finally, our discussion extends to behavior finance, mainly about the dispute between traditional finance and behavior finance, including where behavior finance turns against traditional finance and how EMH responds to the attack of behavior finance. We also summarize the some relevant research on behavior finance briefly and carve out a future from our own perspective.