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Benefits and Pensions MonitorBuy On The Rumour... By: Jim Helik Behavioural finance, and the belief that we are not always coldly efficient decisionmakers when it comes to financial matters, is no longer a fringe subject matter. Yet, if you mention the word ‘rumour’ to most investors, you are likely to be relegated to the fringes of economic theory. After all, behavioural finance issues are grounded in psychology and use big words like ‘bounded rationality’ (the concept that people are perfectly rational as economic theory suggests, but only within a simplified version of reality – there are limits or boundaries to an individual’s rational behaviour). But rumours are synonymous with ‘gossip’ and seem to belong to another part of investment theory altogether, along with market panics and other highly irrational actions. Two new books look at rumours and, surprisingly, find some structure to the role that they play in investment behaviour. Mark Schindler, in Rumors in Financial Markets, notes that financial markets are fruitful ground for rumours since they involve a limited number of people who have to make risky decisions under constant stress, all while being flooded with news. Rumours are far from irrational and, in fact, follow a number of logical rules. Made Up Fantasy While the ‘basis’ for rumours can range from an actual event or just a made up fantasy on the part of one or more individuals, trying to understand the source of a rumour is a moot point (as well as being almost impossible to determine). Surveys of traders found that, by and large, they spend little time trying to evaluate the source of a rumour. Rather, they care about the market’s reaction to the rumour. If the price of the stock or commodity moves, that is all the indication most participants need that the market believes the rumour to be true. Individual investors, by comparison, seem to devote great effort to determining the source of a rumour and, on average, claim to know the source of a rumour far more often than do floor traders (what the behavioural finance folks call the overconfidence bias).
Rumours do not spread and evolve in any predetermined way since they are a consequence of peoples’ behaviour. People spread rumours in financial markets to convince others about their existing point-of-view, but also to probe for additional, accurate information. Market participants hope that, by speaking about a rumour to others, they can either validate it or obtain better, more accurate facts on which to base their investment decisions. Their frequency is higher in volatile markets, matching the need for additional information in uncertain times than in non-volatile markets. And all market participants seem to agree that with today’s more tightly linked financial community, rumours spread far faster than they used to. Factual Reasons The importance of rumours is further explored in Robert Bruner and Sean Carr’s The Panic of 1907: Lessons Learned for the Market’s Perfect Storm. What happened in 1907 was more than just a one-off stock market decline, though this was a pretty big one – an overall fall of 37 per cent. There were many solid, factual reasons for such a decline at that time, including:
However, just as importantly, there were behavioural issues – a bubble economy based on rising expectations that was just ripe for a fall and how existing bad news leads to the expectation of more bad news to come, thus continuing the downward spiral and general economic panic. In a time when real news was hard to come by and when any key data travelled slowly, rumours spread to fill the gap created by a lack of information. In other words, rumours were a logical response to the issues at the time, not an irrational one. So rumours seem to have a place in our financial lives. The traders surveyed by Schindler regard any price movement as a sign of the market’s belief in a rumour and appear to be happy to trade on these findings. So the herd may not always be economically rational in their approach to financial matters, but they do end up moving markets. And you can’t go wrong trading against the herd, can you?
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Jim Helik is co-author of ‘Strategic Wealth Conversion,’ a textbook published by the Canadian Securities Institute. He also teaches at the School of Business, Ryerson University in Toronto.