The stock market is one of the most volatile economic markets in modern times. Investors are extremely sensitive to any news about macro and micro factors which may affect the prices of stocks. There are many factors that can cause stock prices to change drastically.
Predicting what a market will do in response to the particular news would be impossible. Here we will discuss some common causes that cause stock prices to move significantly in a short period of time.
Let's understand the over and under reaction of news in both good and bad news case scenarios.
Overreaction of a good news
An overreaction to good news can lead to an unsustainable increase in stock prices that may eventually correct itself. Suppose the positive news is not sustainable, such as a one-time event or an anomaly. In that case, the market may eventually correct itself, causing the stock price to drop back down to a more reasonable level.
If a company announces better-than-expected earnings, investors may bid up the stock price in anticipation of future growth. If the market overreacts to this news, it can lead to a bubble or a speculative frenzy, where investors continue to buy the stock at increasingly higher prices based on the assumption that the good news will continue indefinitely.
Overreaction of a bad news
When a company or the market experiences negative news or events, investors may react emotionally, leading to a rush to sell stocks. This increased selling pressure can result in a rapid drop in stock prices, which can exacerbate the impact of the bad news.
If a company reports a decline in earnings or revenue, investors may panic and sell off their shares, even if the company is still fundamentally strong and has a bright future. This rush to sell can lead to a significant drop in the company's stock price, which can, in turn, affect the broader market if the company is a major player in its industry or sector.
Under reaction to a good news
If the market initially reacts to good news, it may take some time for the price of the affected securities to fully reflect the positive information. This delay could create an opportunity for investors who identify the underreaction early to buy in at a relatively low price and profit as the market gradually adjusts.
If there is good news about a company and investors do not identify the potential growth a particular company has, it leads investors to lose an opportunity to create wealth. On the other hand, companies may have to face undervaluation, due to which growth is affected.
Underreaction to a bad news
An underreaction to bad news can occur when the stock market does not immediately adjust its prices to reflect the negative information. If the market reacts to bad news, it could result in a delayed reaction to the negative information, which could lead to an eventual correction in stock prices.
If there is bad news in the market about the company, investors still buy the stocks of a company by under-reacting to the information. It leads an investor to invest in fundamentally weak companies, which depreciates their wealth.
In any scenario, over and under reaction to the news results in panic in the stock market, which ultimately leads you to the wrong investment decision. It is necessary to understand the importance of patience and reacting rightly to market news.
Anushka Trivedi is a freelance financial content writer. She can be reached at anushkatrivedi.com