Explanation

The correct answer is B. loss aversion.

Understanding the Overreaction Anomaly

The overreaction anomaly refers to the tendency of investors to overreact to new information, causing asset prices to move more than justified by the fundamental information. This behavioral bias leads to price momentum and subsequent reversals.

Why Loss Aversion Explains Overreaction

1. Loss Aversion Concept: Loss aversion is a key concept in prospect theory developed by Kahneman and Tversky. It describes how people feel the pain of losses more intensely than the pleasure of equivalent gains (typically about 2-2.5 times more).

2. Mechanism of Overreaction:

   • When investors receive negative news, their loss aversion causes them to react more strongly than warranted
   • They may panic and sell excessively, driving prices below fundamental values
   • Conversely, with positive news, they may become overly optimistic and bid prices too high

3. Contrast with Other Options:

   • A. Risk aversion: While related, risk aversion is a traditional finance concept where investors require compensation for bearing risk. It doesn't specifically explain the behavioral bias of overreacting to information.
   • C. Sudden changes in economic fundamentals: This describes actual market events, not a behavioral explanation for why investors overreact to those events.

Behavioral Finance Context

In behavioral finance, loss aversion helps explain several market anomalies:

• Overreaction to earnings announcements
• Momentum effects
• Post-earnings announcement drift
• The disposition effect (selling winners too early and holding losers too long)

Evidence and Research

Research by De Bondt and Thaler (1985) found that stocks that performed poorly over 3-5 years (losers) tended to outperform in subsequent periods, while past winners tended to underperform. This reversal pattern suggests investors overreact to both good and bad news, consistent with loss-averse behavior.