Home Kuo’s Smart Take Smart Thought Of The Week: Overreaction

Smart Thought Of The Week: Overreaction

Some things never change. Markets overreact on the upside when news is good. And they overreacts on the downside when the news is bad. Overreaction, and its ugly cousin, volatility, is something that we must learn to accept when we invest in shares.

Thing is, overreaction is an emotional response that is, in turn, prompted by the basic human instincts of fear and greed. When we see a stock rise, we can’t help but want a piece of the action. When we see a stock price fall, it is natural to want to cut and run.

Overreaction in the market has been in abundance since the start of the COVID-19 pandemic. Once it became evident that the virus could not be contained, stock markets fell with alarming speed. Shares in the travel-related sector were, understandably, hammered….

…. So too were shares in some retailers, banks, property companies, and insurers. Nobody bothered to ask if valuing companies at just a fraction of their book values or treating many companies as total basket cases were justified. For some traders, it was simply a case of getting out at any cost.

At the same time, shares in companies that catered to people working from home rose. These included the many internet retailers, companies that provided streaming content, eateries that were geared up for home deliveries, and logistics companies.

Again, nobody really asked if their lofty valuations were justified. Traders simply bought anything that was going up.

Thing is, when we invest, intrinsic values matter. A share cannot continue to exist too far below or too far above its intrinsic value because in the long run its valuation must matter.

That is the basis of investing rationally. Unfortunately, the market is not always rational. The market is not always able to perfectly (if at all) price in all publicly available information. Instead it can be affected by emotional biases.

So, what should rational investors do?

It’s quite straight forward. It is summed up in 20 wise words by Peter Lynch: “Buy only what you understand, believe in, and intend to stick with – even when others are chasing the next miracle”.

At some point, this pandemic will end. Exactly how it will end is anyone’s guess. But it will end. And for the patient investor who has remained focussed, valuations, just like our lives, will return to normalcy….

…. when that happens many will wish that they had learnt not to trust their gut feeling but were disciplined enough to ignore them.

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Disclosure: David Kuo does not own shares in any of the companies mentioned.