Everything that is publicly known is already reflected in current stock prices. But as a scientific study shows, only a few people are aware of this. And that leads to investing mistakes.
Suppose the sporting goods maker Nike announces that it will cut its production costs by 20 percent. And suppose further that this became known four weeks ago. Experts now predict that this unexpected success will significantly strengthen Nike's market position in the sportswear industry. Would you conclude from this that now is a good time to invest in Nike stock?
The example comes from an article by Peter Andre, Junior Professor of Behavioral Finance, economics doctoral candidate Philipp Schirmer, and Johannes Wohlfart, Professor of Economics. In it, they shed light on some of the findings of their study "Mental Models of the Stock Market". And it brought some interesting insights to light.
The market already knows
One key result: most academics regard older news as irrelevant to a stock's further price development. By contrast, a great many investors - but also numerous finance professionals - believe that even older good news can still justify higher return expectations after a while. This is closely connected to another finding of the study: while researchers trust in market efficiency, investors, as well as many finance professionals, equate higher company profits with higher future stock returns.
Prof. Dr. Stefan May, Head of Investment Strategy at Quirin Privatbank and at quirion, finds the study's results "highly interesting and revealing" - above all because the research team surveyed not only American and German private households, but also financial advisors from the US and fund managers from Germany. "The efficient market hypothesis states that all publicly available information is immediately reflected in prices," explains May, now Professor Emeritus of Banking, Financial Market Analysis, and Portfolio Management. "The 'good news' is therefore already priced in, and it makes no sense to then use that information as the basis for an investment decision at some later point."
Investing beyond the "news"
There's nothing as old as yesterday's newspaper, as the saying once went. In the digital world and on the stock markets, everything moves even faster. "In principle, you shouldn't invest money on the basis of news about companies," May observes. In practice, though, this happens often. Investors search for the supposedly "right" stock at the supposedly "optimal moment." That often goes wrong. In any case, an investor's return can frequently fall short of what might have been possible in the market.
If the market knows everything that is known: does that also mean it is never wrong? "On the stock market, expectations about the future are traded, but the future itself remains unknown," May explains. "It's true that irrational expectations also feed into prices. But when they aren't fulfilled, corrections follow." One has to keep in mind, he says, that a price comes about when there is a buyer and a seller at a given price. "Both sides have, in a sense, opposing expectations."
Compelling stories fascinate us
Taking the consequences of the efficiency hypothesis into account when investing isn't always easy. Not even for professionals. Why is that? "That's mainly for psychological reasons," says May. Compelling stock market stories are simply incredibly appealing. "I admit that when I hear a well-crafted success story, even I sometimes briefly forget the rational arguments of science."
One shouldn't underestimate, either, that lucky breaks do happen: "You buy a stock and it leads to success. That can't be repeated systematically, but it does happen from time to time." Once you've had an experience like that, it's very hard to look at investing in purely rational terms. "It's human nature to attribute luck not to chance but to one's own abilities."
But what does it mean to approach investing rationally? "First of all, to invest money in the stock markets at all," May states. "Stocks give you a stake in companies, and the stock markets therefore in economic development." Because the economy is geared toward growth, the trend on the stock markets is, over the long term and on average, upward. "What's important, though, is not to simply put your money into some random stocks, but ideally to diversify the portfolio according to scientific criteria and globally, efficiently with ETFs." That's how return opportunities and risks can be brought into an individually suitable balance at low cost. And then the success of an investment is no longer a pure "stroke of luck," but rests on a systematic approach to investing.
