The underreaction hypothesis holds that investors are too slow to incorporate new information into asset prices — they adjust their expectations gradually rather than immediately and fully when new data arrives. This sluggish updating is the behavioral foundation of the momentum effect: because prices adjust slowly to new information, assets whose prices have been rising tend to continue rising (good news was underreacted to), and those that have been falling tend to continue falling (bad news was underreacted to).

The Evidence for Underreaction

Post-earnings announcement drift (PEAD) is one of the most compelling pieces of evidence for investor underreaction. When a company reports earnings that significantly exceed or miss expectations, the price typically moves strongly on the announcement — but then continues moving in the same direction for days, weeks, and even months. If investors had fully incorporated the news immediately, the post-announcement drift would not exist. But because many investors adjust their expectations slowly, the full price impact of a significant earnings surprise takes considerable time to be reflected fully.

Why Investors Underreact

Several behavioral mechanisms contribute to investor underreaction. Anchoring — the tendency to rely too heavily on prior beliefs and adjust insufficiently when new information arrives — directly produces underreaction. Information processing limitations mean that large amounts of new data cannot be fully digested immediately. Institutional inertia — the tendency of large investors to adjust positions gradually to avoid market impact — slows the price response to new information. And the diffusion of information through professional networks means that not all investors receive or act on new data simultaneously.

Investment Implications

Underreaction creates exploitable momentum opportunities. Systematic momentum strategies — buying recent winners and selling (or avoiding) recent losers — profit from the gradual price adjustment that follows new information. Trend-following strategies, which follow price trends without requiring knowledge of the underlying cause, benefit from whatever combination of underreaction and momentum-chasing sustains trends. The persistence of the momentum effect across markets and decades reflects the durability of the behavioral forces driving investor underreaction.

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