Think Like the Great Investors: Make Better Decisions and Raise Your Investing to a New Level

Chapter 16

What is it worth? (overreaction)

Investors never cease to be surprised that the stock market often seems to overreact to news. Bad news drives the prices of stocks down by more than would seem warranted by the new information. Likewise when the announcements are good, the prices of stocks seem to rise by far more than a reasonable analysis would expect.

This comes as a surprise to most beginners, because they have been led to believe by academics that markets are efficient. Efficient is a jargon term meaning that information flows rapidly through the market and is accurately assessed by smart investors, who will quickly adjust the price appropriately. There is the expectation that markets should not overreact to news, or if they do, that the overreaction is soon arbitraged away by smart investors.

Arbitrage is another jargon term that refers to the process by which discrepancies in prices are closed in actively traded markets. A simple example is to take a stock that is trading at $5.00 on the New York stock market and at $5.20 on the London stock market. An arbitrageur can profit by buying in New York and selling in London. Soon, the price will tend to rise in New York and fall in London until the opportunity represented by the price discrepancy is no longer there.

In the situation we are discussing, the appropriate price might be $5.20, but the market has overreacted ...