Whenever we investors buy anything we become possessive about the entity owned. Be it automobile, house or even the stocks. We become too streamlined to hear anything related to our owned assets.
Any news positive or negative is important for almost every investor for their stocks. A piece of positive news instills confidence which leads us to buy more stocks and on the other hand negative news instills fear leading us to sell or short.
The story looks familiar, isn’t it? But, this is what that goes in creating demand and supply for the stock. Accordingly, stock price moves to match new demand-supply equation created by the spontaneous reaction of buying selling of investors.
This phenomenon is not restricted to India only. It has an impact throughout the globe. Even historically, researchers had tried to find whether there was any correlation between the news and the stock price. The correlation obtained claimed that there is a small inter-relationship between these entities.
In this article
Let’s first see what the purpose of newspapers or news channels is
Newspapers and news channel are medium investors can take well educated, information lead decisions.
There are many newspapers and channels available in the market. The only way to excel and compete with other news sources is to increase reach and penetrate deep in the market. This allows news channels to increase their market share and eventually revenue.
As the ultimate motive is to increase market share, some news broadcasted might have some element of air and no concrete material. They might be just to increase publication and its circulations in the area.
So, as new investors should we react to every news?
There is a concept in behavioral finance called availability bias.
Availability bias is a bias in which investors tend to form and concretize their decisions more heavily from the most recent information available. Thus, decisions and opinions become biased toward the latest news.
The investor is in constant search for news. Any news that arrives in the media overshadows past signals that a company made as a strategic strong step towards long term goal.
Herd mentality is also one of the major factors that we investors cannot escape easily. When news arrives in the market, many investors react instantaneously. Seeing these investors we often leave our findings and views about the stock and follow them.
These noise traders make investors like us believe that our research might have missed some major factor used for valuing the company. Ultimately, we follow the herd.
So, should we not react to any news?
The answer is “No”.
Surprised? We should react to news that is related to the functioning of the company, any major merger, and acquisition or even news that are related to the governance of the company.
We should not have any psychological filter for news, this is known as conformity bias in the behavioral finance world.
Conformity bias is a bias in which investors only react to news according to their position of the stock. For example, if an investor is long on a stock. He / She might just be biased to positive news of the company through the magnitude of the news be minuscule. The worst part is he/she might miss potential red flag news.
Red flags are those financial warning signs that if a company makes, its future earnings are in trouble and it is possibly going to underperform.
Regarding companies which are publically traded, red flags may appear in the quarter or annual financial statements compiled by the company’s chief financial officer (CFO), the auditor, or the accountant. These red flags are signs that may signal some future financial distress or underlying problem within the company.
In this case, the stock price is bound to fall due to the red flag and the investors feel disgusted as he/she has followed the stock actively, mapped news but with bias. Ultimately, the investor ends up making a loss.
Are good/bad news signal buy/sell always?
The general perception among investors like us is that whenever good news comes a smart choice is to go for buying the investment option. But, every time this doesn’t hold true.
Let’s take the example of Sun Pharma stock. Sun Pharma is a pharmaceutical company originated in India. It manufactures and sells drugs majorly in the US. The company had plans for its specialized drug to be launched in the US, but unfortunately, there were non-compliance issues with USFDA (United States Food and Drugs Administration) norms.
When the USFDA team visited Sun Pharma’s Halol manufacturing plant, investors took it as positive news. The stock price began to climb. After some time when the findings by FDA team were not as the investors thought, the share price of Sun Pharma again plummeted.
So from an investor’s perspective, if we had to sell our stock instead of buying we would have gained better. These are the following reason why in this case stock selling is more helpful than buying:
- As the news is somewhat good, investors will tend to buy the stock. Hence, one would get a buyer easily.
- The magnitude of the news is such that more positive news can flow. Thus, the news is indicative, not concrete.
- The target market was the US pharmaceutical market. This market itself was going through a mild rough patch.
Thus, news can provide investment opportunities. These opportunities are rather arbitrage opportunities in the hindsight. We investors have to look for such signal and might have to take an opposite view to reap short term gain. A small technical analysis is helpful along with news.
Noise trader pitfall
Let’s look at who noise traders are.
Noise traders are investors who make decisions of buying and sell trades for stocks without the support of basic fundamental analysis, professional advice or advanced analysis.
These investors typically follow live trends and tend to overreact to good and bad news. The trade execution typically happens within minutes of the news airing. The demand-supply adjusts the price of the stock.
Stock price movement may temporarily breach current resistant or support level. This makes investors with limited funds like us act upon our position in the stock. The impulse of change is for a limited time and then gradually it disappears.
Hence, following the herd without proper fundamental analysis would impact investors like us badly. The lure here might be a small cloud 9 moment till the noise trading dust settles.
In short, trading by noise traders tends to be a pure gut impulse deriving from irrational exuberance, greed or even fear.
News against our position in the stock
Let’s say we have a long position in the stock, i.e. we have bought the stock and are waiting for an increase in price. On a fine afternoon, you switch on your television and find negative news on the news channel. What should you do? Immediately react and sell the stock? Do nothing?
The answer to this lies in the fundamental analysis we investors did while selecting the stock. We had analyzed various factors. Then these factors and their future perspective leads us to go for buying the stock.
The current financial market is close to Eugene Fama’s efficient market, where most of the information in this digital era is publically available.
Noise traders will act in no time and this would lead to a decrease in the price of the stock. We shouldn’t panic. If we are very confident of the company’s fundamentals and the news is not a red flag, it is a golden opportunity to buy more stocks at a discounted price.
For long term investors, this will work wonders as the payoff will naturally increase.
News of all sorts is available to us. It becomes our choice when to react and when not to react. We investors should have fundamental analysis at our perusal for making better decisions.
We should be aware of noise traders and how they stretch the price on either side. Also, news provides arbitrage opportunities – those should not be missed for short term or long term gain.
We need to understand that certain news is just to tinkle the market while some are game changers. Proper action, planning, and patience are required.
Disclaimer: the views expressed here are of the author and do not reflect those of Groww.