When the sharemarket fluctuates, market players scramble for information to make sense of the market over or underreaction. But did you know that investors tend to put more weight on recent news rather than looking at longer-term information?
Understanding how and why markets overreact can give savvy investors an edge in trading. It provides an opportunity for investors and traders to increase the probability of success when buying into certain stocks.
Below are some examples of highly fluctuating stocks:
This is not about trying to pick the lows in price. What I do want to encourage is that you recognise that market overreaction can present an investment opportunity.
Richard Taler & Werner FM De Bondt published a paper back in 1985 titled ‘Does the Stock Market Overreact?’ It found that stocks tend to regress back to the mean.
They also found that when new information comes to the market, market players tend to overweight the new information and underweight old information. In other words, there tends to be a bias towards acting on information from recent developments in a company and discounting old news.
By keeping a level head while a stock may be getting punished you could have a great opportunity to profit.
If you consider the long-term news along with more recent information, and recognise that eventually the price will regress back to its mean, you’re better off waiting for the stock to form a bottom first before buying.
Of course, recognising the bottom is half the battle.
These buying opportunities tend to have binary outcomes. That is, they offer large profits or no profits.
If a company’s share price looks like it’s bottoming out, make sure the company doesn’t fall in the latter category of offering no profits. Always make sure the company is likely to remain solvent. You don’t want the company to file for insolvency or bankruptcy. You want the company to recover and get back on the profit-climbing ladder.
You know what they say: when you are down and out, the only way is up.
Often, if a company continues to make mistakes, it won’t survive. So most companies will try new business strategies, like replacing management, and generally focus on being better at what it does.
Just make sure you do your homework.
You can recognise overreaction and under-reaction through technical indicators such as the Relative Strength Index (RSI).
An RSI reading below 30 shows that the market/stock may be oversold and a reading above 70 shows that the market may be overbought.
The graph below shows the S&P ASX 200 in black and the RSI for that index in purple. You can see that over the last four months, the market has been bounded by an RSI of around 60 (the green dotted line) before selling off. So at around the 60 mark, we’ve seen the market pulling back.
(You can email me at moneymakers@belldirect.com.au for a larger version of the chart.)
Make sure you don’t use this technical indicator in isolation. The RSI is prone to many false indications and there’s nothing foolproof in its interpretation. It is absolutely useless during a trend. For example, an up trend causes a continuously overbought indication, while a downtrend pushes it into permanent oversold mode.
On its own, the RSI’s utility is questionable, but when combined with other techniques it really comes into its own.
So make sure you consider the notion of market overreacting.
Happy trading!
Julia Lee Equities Analyst Bell Direct Have you started trading with Bell Direct for just $15 a trade? Register now for free.