Overreaction Theory

Overreaction Theory suggests that financial markets often respond disproportionately to news or events. When investors perceive new information, they may overestimate its importance, leading to exaggerated price swings—either upward or downward. This overreaction creates opportunities for traders to profit by buying undervalued assets or selling overvalued ones once the market corrects itself. Essentially, the theory highlights how human emotions and biases can cause market movements that deviate from fundamental values, emphasizing that not every price change reflects true underlying changes in an asset’s worth.