Testing the UK stock market overreaction

The overreaction hypothesis asserts that investors tend to violate the Bayes’ rule where they overreact to unanticipated and dramatic news or events in the financial world. This is consistent with the Representativeness Heuristic (Grether 1980) which is used as a basis for testing overreaction in the market. This paper scrutinises the behaviour of the UK stock prices in relation to the financial crisis (credit crunch). An event study is carried out for the period of 2004-2009 for the portfolios of Winners and Losers which have been assigned using quintiles of the best and worst performances of the sampled securities. Monthly data over the period shows clear evidence of stock overreaction behaviour in the UK market. The data is then split into sub-periods for further investigation which analyses the development of the overreaction of the market. The results of the overreaction have also been used as a proxy for the confidence level of investors in the market following global financial health. This provided evidence that in this case as the overreaction in the market decreases, the confidence in the market increased providing an indication of the mean starting to revert to its position