Does the Stock Market Overreact?

In short……you bet it does! Professors, philosophers, psychologists, academics…..you name it, have all done studies on behavioral finance to determine if the market overreacts, and why. If one thing is certain, it’s that psychology affects investor behavior. Classic economic theory assumes all people make rational decisions all the time and always act in ways that optimize their benefits. Well, wouldn’t that be nice if it were true? Unfortunately it couldn’t be more inaccurate. Behavioral Finance recognizes people don’t always act in rational ways, and it tries to explain how irrational behavior affects the stock market.

Markets tend to overreact to unexpected and dramatic news and events, with investors giving too much weight to new information. As a result, stock markets often are buffeted by bouts of optimism and bouts of pessimism, which push stock prices higher or lower than they deserve to be.

According to Howard Marks, “in order to be successful, an investor has to understand not just finance, accounting, and economics, but also psychology.” We couldn’t agree more.

When markets become volatile, it’s a good idea to remember your long term goals. Stay disciplined, and don’t let other people’s mood swings (or the market’s mood swings) affect your financial destiny. Like Benjamin Graham said, “in the end, how your investments behave is much less important than how you behave.”