underreaction

Underreaction is a behavioral phenomenon in which response to new information is smaller or slower than warranted, causing gradual adjustment rather than immediate correction. In finance and economics, underreaction refers to markets or investors not fully discounting new information, leading to delayed price changes and momentum in asset prices. It is contrasted with overreaction, where prices overshoot and subsequently reverse. Empirical work on stock prices shows that prices often move in the direction of surprise earnings or news for several weeks to months, rather than immediately fully incorporating the information. Causes include limited attention, information diffusion lags, cognitive biases such as anchoring and conservatism, and skepticism about the reliability of new data. Behavioral models, such as prospect theory extensions and Bayesian updating with biased priors, illustrate how underreaction can arise from underweighting of new evidence.

Beyond markets, underreaction appears in public policy and risk communication when people or institutions discount the salience or probability of rare events, leading to inadequate or delayed responses to emerging risks (e.g., climate risks, health scares). It can interact with institutional incentives, liquidity constraints, and media coverage, which shape how quickly information is acted upon.

Measuring underreaction relies on event studies, momentum analyses, and changes in trading volume or volatility following news. Critics note that apparent underreaction may reflect heterogeneity across assets, risk adjustments, or competing explanations (e.g., liquidity effects). The concept remains a core idea in behavioral finance and decision science as a counterpart to overreaction and to calibration problems.