Stock Market Psychology: How Investor Overreaction And Underreaction Can Move Prices

Markets don’t always move in straight lines. Sometimes, a stock soars far higher than the news seems to justify. Other times, it barely budges even after a big announcement. These swings—too much, too little—can feel puzzling, but they’re not random. They are driven by human psychology and its interaction with investing.

This is where behavioural finance comes in. It studies how emotions, biases, and mental shortcuts influence financial decisions, showing why investors may overreact or underreact to information. And while these tendencies don’t guarantee outcomes, they help explain why markets sometimes swing past the truth before settling back.

Table of contents

• What overreaction looks like
• What underreaction looks like
• Why these swings happen
• What investors could do
• The bottom line

What overreaction looks like

Overreaction happens when investors push prices far beyond what the fundamentals seem to suggest. Imagine a company posts strong quarterly results. Excitement builds, headlines pour in, and its stock price rises – but more than what the earnings surprise may merit. Later, when the enthusiasm cools, the price may drift back down.

Academic studies have echoed this. For instance, in Does the Stock Market Overreact (1985)? Werner FM De Bondt & Richard Thaler studied the performance of US stocks and found that companies that had recently performed very poorly often went on to outperform those that had recently done very well over the following years. This pattern suggests earlier moves might have overshot reality and eventually reversed. That doesn’t mean reversals always happen, but it highlights how markets can swing too far when emotions run hot.

Past performance may or may not be sustained in future.

Read Also: Trading Psychology: Concepts, Basis and Importance

What underreaction looks like

Underreaction is the flip side—prices don’t move enough, at least initially. A classic example is post-earnings announcement drift (PEAD). When a company delivers a positive earnings surprise, its stock price usually jumps right away, but it may continue climbing for weeks or months afterwards. The idea is that investors might not fully absorb the news immediately.

Another case is momentum investing, where stocks that have gone up recently tend to keep rising for a while. This suggests the market might take time to fully adjust to new trends. Of course, these effects can fade or vary over time, but they illustrate how prices sometimes lag behind information, owing to underreaction or delayed reaction.

Why these swings happen

Psychology offers clues for both behaviours. Overreaction can be tied to the representativeness heuristic, where people judge by vivid stories or recent streaks instead of probabilities. A hot stock feels like a “winner,” and investors pile in, even if the fundamentals don’t fully support it.

Underreaction, on the other hand, connects with conservatism bias—the tendency to update beliefs too slowly when faced with new data. Investors may be cautious, waiting for confirmation before changing their views, which delays price adjustments.

Other theories highlight overconfidence (investors placing too much weight on their own judgment) and self-attribution (taking credit for gains but blaming luck for losses). These can fuel both overreaction and underreaction at different times.

Read Also: Investor Psychology During Market Crashes: A Look Back

What investors could do

While no approach eliminates risk, being aware of these patterns might help investors avoid extreme decisions. A few practical steps include:

• Pause after headlines. Waiting before reacting to dramatic news could reduce the urge to jump into an overheated trade.
• Stay disciplined. A simple, rules-based review process might help ensure you adjust to new information without dragging your feet.
• Use base rates. Comparing a company’s story with long-term averages could counter the pull of short-term excitement.
• Diversify and rebalance. Sticking to a pre-set plan can limit the temptation to chase hot stocks or cling to laggards.
• Reflect on past behaviour. Keeping a decision journal might reveal whether you personally tend to overreact or underreact.

Read Also: Investor Emotions & Market Cycles: A Behavioral Guide

The bottom line

Behavioural finance doesn’t claim markets are always “wrong.” Instead, it shows that because markets are made of humans, they may overshoot or lag before eventually correcting. Recognising these swings—whether overreaction or underreaction—could help investors approach decisions with more patience and balance.

At the end of the day, markets swing past the truth not because the math is flawed, but because people, biases and emotions are involved. And understanding that human element is an important valuable lesson that behavioural finance has to offer.

At Bajaj Finserv AMC, we recognise that emotions are the cornerstone of investor behaviour – not just for investors but for investment professionals too. That’s why, behavioural finance is at the heart of our investment philosophy, InQuBe, which combines the Information Edge, Quantitative Edge and Behavioural Edge. By understanding, tracking and monitoring market sentiments and our own investment biases, we seek to make mindful and strategic investment decisions. Get the Behavioural edge by investing with Bajaj Finserv AMC. Read more about InQuBe here.

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