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9:52 am - Saturday December 7, 2019

Buy on the Rumor – Sell on the News: Our Psychology at Work

| Investing, Psychology | Rating: 4.5
by Numan

A counter intuitive rule of thumb explained

Rumors of new products, earnings, takeovers and mergers immediately raise share prices. This is understandable as the value of the company is expected to rise as a result and so investors who believe the rumor to be true (or true enough) can buy on the rumor with the hope of generate significant returns in a short time.

Sell on the news is more intriguing. Usually this tested rule of thumb works. Many times after the news the share’s price shows signs of uncertainty and fear of the recent height it had attained. The reasons why can shed some light on how our psychologies play yet another trick on us.

Shouldn’t buying on the news be more appealing?

Solid investors should not buy on the rumor. Rumors have a tendency to turn out to be false and the share’s price soon follows to previous or lower levels. Still, buying on the news is more often than not too late for any short-term profit. Shouldn’t buying on the news be more appealing?

It seems rumors excite the imagination of investors so that by the time the news gets out it’s often disappointing by the mere fact it is grounded to a certain reality. I think something deeper, rooted in our psychology is at work, and I will expand on it shortly.

For the value investor buying on the news is the sound path for the long term. It is understandable how buying on the rumor may generate higher short-term returns as the associated risk is much higher since rumors may turn out to be false. Still, if you are not a speculator look for the hidden value in the news.

It is important to remember that many times the thought or idea of a certain takeover or merger is more exciting than the actual results. As we know everything is personal and merging two companies, two boards and two managements is hardly an easy task. An idea of a merger may be brilliant at first but if the operational and practical side is weak the merger is doomed.

Buy on the rumor sell on the news – the psychology at work

The more interesting aspect of buy on the rumor – sell on the news is the psychological aspect at play. This rule gives us another good example of how fragile our minds are and why the market is a place for the more rational.

Over and under corrections and the confidence bias – Think of the first think that comes to your mind when you hear a rumor regarding a company. We all believe the share prices will sky rocket and are sorry for missing the opportunity. A rumor of an opportunity has a very strong effect on us. Our psychology usually leads us to see the up side of such an event ignoring the limits and limitations that exist. Our optimistic view is quickly generated into a peak in the share’s price only to later face reality and correct the price back downwards to reflect reality and overshooting.

Expectations and reward pursuit – Strangely enough we seem to value some thing more when we wait for it to come true than we do when it finally does. This psychological bias has been demonstrated in research and is rather intuitive once you consider it.

When you plan a trip and consider all the wonderful activities you will enjoy your perceived utility is much higher than it actually is when participating in these activities. When expecting a raise, for example, its perceived value is higher than when you’ve already received it. The mechanism seems to be intuitive as well. Evolution has programmed us to constantly seek new rewards and never settle for what we already achieved.

Therefore, the perceived value of a certain rumor is more often higher than the actually value once it turns out to be true.

Psychology and investing go hand in hand. I find this connection fascinating and I’ve written quite a few posts about it exploring the different aspects and tricks our minds play on us. We can’t always control our psychologies but we can try to offset some of the bias and use it for our benefit.

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