Wednesday, December 22, 2010

Behavioral Finance

"Buy on the Rumor:" Anticipatory Affect and Investor Behavior

 
I'm citing an interesting behavioral finance article here, "Buy on the Rumor".   
The traders’ aphorism “buy on the rumor and sell on the news” (BRSN) describes a strategy for exploiting a frequently observed financial market price pattern.  This pattern (BRSN) is characterized by security prices rising prior to and falling subsequent to positively anticipated events.  Security prices are, paradoxically, often observed to decline following an event outcome that is equal-to or better-than “expectations.”  We argue that investors’ expectations of rewarding event outcomes are inflated by a neuro-affective biasing process.  A disproportionate number of positively anticipated events will yield disappointing event outcomes.
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.  Naïve 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 re-positioning (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.