Theory and Practice
The accepted theory on asset pricing (in the current case stock) is the Efficient Market Hypothesis. It implies that all information is in the price of a stock.
One important aspect which this theory neglects is that there is a mechanism by which information gets converted into price.
Information to Price
Information comes from companies or news outlets and goes to analysts and investors. They then have to make a buy, sell or hold decision about the stock based on information.
The buying and selling of a stock is what moves the price of a stock. The key point here is that a decision ( to buy sell or hold) must be made.
That means that price is not only based on information but also in the way the decision is made. Behavioural and cognitive biases occur when a decision is made.
Biases
Various kind of biases impact buying and selling decisions. Some of the examples of such biases are
- Overconfidence
- Recency effect
- Framing
- Base rate effect
Study of Behaviour
Research shows that during analyst calls company management changed behaviour when they realised that institutional investors were comparing their forecasts to results. Managements went from overstating future earnings to understating them in order to create positive earnings surprise.
Sentiment
Determining the sentiment of investors outside the company is an important challenge. It is as important as the sentiment of management of company.
Companies where executives are nervous, apprehensive or concerned, tend to use more negative phrases. At times corporate managers tend to deflect attention away from something they do not want to talk about.
Over a period of time a lot of research has happened in inter-disciplinary areas such as social and group psychology, sociology, behavioural economics, accounting, marketing and the science of decision making.
This has led to development of many "sentiment indicators".
Consumer Confidence Index - RBI August 6,2020
A gauge of sentiments if what successful investors also thrive on.
(Disclaimer : This blog is for educational purposes and not to solicit any kind of business or provide any kind of advise)
