Buy on the Rumor: Anticipatory Affect and Investor Behavior

Favorite bit (Via Richard Peterson.Net)

We suggest that mathematical descriptions of individual cognitive biases are not useful in forming a comprehensive new paradigm for economic judgment and decision-making. A more systematic neuroanatomical approach toward elucidating the affective processes biasing judgment and decision-making is needed. We and others (Blakeslee, 2002) suspect that affect-based models of judgment and decision-making derived from neuroscience research will be integral to a generalizable model of economic decision-making.

Abstract (Via Richard Peterson.Net)

In this paper we demonstrate a relationship between investor psychology and security pricing around anticipated events. Taking a multidisciplinary approach, we pull together research in the finance, psychology, and neuroscience literature. Event-studies in the finance literature demonstrate anomalous security (stock, commodity, bond, or option) price movements around the dates of anticipated security-related events. From the neuroscience literature we demonstrate correlations between reward anticipation and the arousal of affect (feelings, emotions, moods, attitudes, and preferences). From the cognitive psychology literature we extract evidence for the central role of affect in motivating investing behavior. We briefly outline an investment strategy for exploiting the event-related security price pattern described by the trading strategy, “buy on the rumor and sell on the news.”

Additional Excerpts (VIa RIchard Peterson.Net)

Investors often gamble both on an event outcome and on the anticipated price appreciation as a result of that positive outcome. Anticipation of reward generates a positive affect state. Positive affect motivates both increased risk-taking and increased purchasing behaviors. As the anticipated potential reward approaches in time, investors’ positive affect is increasingly aroused. Following the delivery of an expected reward, investors’ affect regresses to neutral. This post-event net decrease in positive affect leads to more risk-averse, protective investing behaviors such as selling (consummate with the new, less positive, affect-state).

Many naïve investors are not aware that a positive event outcome does not necessarily cause security price appreciation. Naive investors may be surprised by their high levels of risk exposure when the euphoric affect that guided the accumulation of their high-risk positions dissipates following the event. Their diminished euphoria motivates increased caution (risk aversion) and investment repositioning (selling) of high-risk positions. In this market environment, a general increase in selling causes negative price pressure. Price decline alone augments investors’ negative affect and increases risk aversion.

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23. November 2009 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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