Good news, false expectations? How people assess potential returns in the stock market

A study by the Cluster of Excellence ECONtribute published in “The Quarterly Journal of Economics” shows why people often draw different conclusions from company news than financial economics would suggest and how much this has to do with the way they think markets work / Publication in “The Quarterly Journal of Economics”

A study involving the Cluster of Excellence ECONtribute at the Universities of Bonn and Cologne demonstrates that not only retail investors but also financial professionals often assess the potential returns on the stock market differently to what standard models of financial economics predict. This is due to differing ideas about how news on companies affects future stock returns. The study, entitled “Mental Models of the Stock Market,” has been published in the prestigious Quarterly Journal of Economics.

For instance, imagine a company announces that it will be able to reduce its production costs by 20 percent in the future. Although the news is already four weeks old, this does not stop many investors pricking up their ears and buying shares in the company in the hope of ensuring a high return, thinking that the company will be earning more in the future and thus delivering higher returns.

This argument does not hold water, however, as share prices tend to react to new information immediately. According to standard models used in financial market research, therefore, the information will already have been factored into the share price after four weeks. Anyone buying later will thus be paying the higher share price and cannot hope for extra returns simply on the basis of the outdated piece of news.

“When a company announces some good news, many people take this primarily to mean the company’s earnings prospects have improved,” explains Johannes Wohlfart, professor at the University of Cologne’s Faculty of Management, Economics and Social Sciences and member of the Cluster of Excellence ECONtribute. “What they’re quick to miss is that other market players are just as aware of the information and the share price has often already reacted to it.”

For the study, Wohlfart, together with his fellow economists Peter Andre from Goethe University Frankfurt and Philipp Schirmer from the University of Bonn, surveyed over 7,000 people from the US and Germany, including retail investors, financial advisors, fund managers and financial market researchers as well as non-experts from the general public. A thought experiment asked participants to gauge how an old piece of company news would affect the returns on its shares.

The respondents were faced with two scenarios: In the first, the company announces a reduction in its production costs; in the second, the news item is neither positive nor negative (“company maintains supplier partnership”). Importantly, both news items are already four weeks old when the respondents are asked to assess them.

The results demonstrate that people draw very different conclusions from the same information. Some 60 percent of respondents drawn from the general public in Germany, 74 per cent of the German retail investors and over half of the fund managers (58 percent) and financial advisors (63 percent) were still expecting higher returns, even weeks after a positive news story broke. By contrast, most of the financial market researchers (67 percent) did not expect any effect on returns.

The researchers put these differences down to the fact that people use different mental models to evaluate the news that they read, which influences what they focus on and what conclusions they draw from news about companies. Researchers who study financial markets assume that they will be efficient and consider both future profits and the current share price, whereas retail investors focus selectively on a company’s future profits and ignore its current share price.

“Retail investors argue that returns will rise because the company is going to keep earning more and will thus be able to increase the value of its shares,” says Schirmer, who is currently doing his doctorate at the University of Bonn as part of the Young ECONtribute program. “What they don’t think about is how much these shares cost to buy, which will also have gone up.”