At the company level, these events can be in the form of earnings announcements, product launches, etc. People try to predict the outcome of these events and its effect on stock prices.
However, when the events unfold as expected i.e. the consensus had correctly predicted the outcome, the market does not behave as expected. so comes the old saying Share Market Trader, “Buy on rumours, sell on news.”
Believe it or not, despite the absence of so many meetings/events in the 17th century, Joseph de la Vega wrote about this market behavior in 1688 in his book Confusion de Confusions (a brilliant read). De la Vega was a Spanish man of varied interests. He was a diamond merchant, financial expert, moral philosopher and poet living in Amsterdam in the 17th century. In the book, he writes, “An event has a much deeper effect on the exchange than the expected event. When large dividends or rich imports are expected, the price of shares will rise; but if the expectation becomes reality If so, the shares often fall.”
He described this behavior of stock prices as quite natural and explained it logically using the observed behavioral characteristics of both types of investors, bulls and bears. Whenever there is an event where the consensus is expecting a positive outcome, bears usually avoid getting in the way. The bulls become quite optimistic about the situation, and the profit prospects will prompt them to buy more. They tend to be overconfident and no small negative development on the way to the event stops them from their path.
“But as soon as the ships arrive or the dividend is announced, the sellers take on new courage. They calculate that for a few months the buyer – the bull – will not be able to expect much auspicious [new] events,” says de la Vega. With nothing to look forward to for some time, the bulls either take profits or close their excess purchases. The bears, depending on the excesses created along the path of the event Let the sales begin.
behavioral finance research on this phenomenon
Advances in neuroscience and psychology have shed new light on the study of financial decision-making under uncertainty. According to Daniel Gilbert, an American social psychologist and author, while the human brain has nearly tripled in size over two million years of evolution, it has also gained new structures. It gained a new part called the ‘prefrontal cortex’, which acts as an experience simulator.
As humans, we have a unique ability to simulate experiences in our heads before we experience them in the real world. This simulation sometimes also brings about a bias called ‘impact bias’. This is a tendency to overestimate the intensity or duration of future feelings and emotion states.
Now, as we know, when an event is expected, people anticipate the outcome and its effect on stock prices. If the outcome is likely to be positive, we exemplify the pleasure of profiting from it. If the event is significant and its consequences are vivid and easily visualizeable, it starts to attract a lot of attention. Everyone is talking about it and analyzing it. A positive narrative is formed and leads to animal husbandry.
A fascinating research paper by Richard Peterson, highlights that “reward anticipation produces a positive affective condition. Positive affect induces both increased risk-taking and increased buying behavior.”
Rising prices reinforce the trend and reduce investor risk. ‘Myopic Discounting’ takes effect as we move towards the event. This refers to the tendency to prioritize near-term rewards over the long term. “As the anticipated potential reward approaches over time, the positive impact of investors is growing rapidly,” says Peterson.
By the time the date of the event is reached, much of the upside from the outcome, the consensus hoped for, ends. New and inexperienced investors can still continue to come to this level. Once the event happens and the outcome is as expected, no matter how good, the trend starts to reverse. With nothing to proceed immediately, profit booking is triggered; Change from risk taking to risk aversion. The price decline confirms the change in trend and starts consolidating the downside move.
Should we change the way we look at important events?
According to Richard Peterson, the “buy on rumours, sell on news” pattern works when these conditions are observed:
- The potential rewards from the event are easily visualized and there is widespread public recognition of the potential reward (if everyone is clarifying).
- There is minimal dissemination of information about event risks and minimal investor conditioning or experience for event risks (investors are either seeking the risk or do not understand the risk)
- As the event nears and average security trading volume (upward momentum = higher expectations) the price moves higher.
Dealing with such market discrepancy caused by investor behavior requires an intelligent investor to assess which outcome is already worth the price and which is of value left on the table.