Putting financial news – good or bad – in context

Markets are not always rational and it is not wise to try to outguess them

Lisa Shelton

Investors’ reaction to economic news can be baffling. For example, positive economic announcements, such as an uptick in gross domestic product (GDP), stronger-than-expected earnings by bellwether companies or a drop in unemployment are sometimes followed by a market sell-off. If the market’s negative response to seemingly good news has left you wondering if you are missing something, you are not alone.

Are markets rational?

The evolving field of behavioral finance may provide some explanation for seemingly irrational investor responses to good or bad economic news. The discipline seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to understand why people make irrational financial decisions.

Practitioners have identified a set of behavioral biases that may explain apparently unreasonable market movements. These include, but are not limited to:

Fear of regret and loss aversion – The threat of potential disappointment or short-term loss are powerful forces that often inspire second-guessing of portfolio strategies, frequently causing investors to sell winning positions too soon or to hold losing positions too long.

Overconfidence – Self-confidence might make people happier, but it doesn’t make them better investors. Overconfident investors tend to overestimate their knowledge, underestimate risks, and exaggerate their ability to control events.

Anchoring – This behavior involves basing decisions – anchoring them – on events or estimates even though they may not reflect relevant long-term trends or statistical probabilities.

Focus on what matters

A landmark study by the New York Federal Reserve on the effect of economic news on the markets may add additional perspective. “How Economic News Moves Markets*” suggests that only a handful of economic announcements – nonfarm payroll numbers, GDP advance release and a private sector manufacturing – affect prices in significant and systematic fashion, while most other releases tend to generate erratic or insignificant price responses.

Generally, it’s advisable to avoid trading on news alone, as it is impossible to consistently gauge investor reaction. Also, markets tend to trade on future expectations over the long-term, so keep that in mind as you confront the aftermath of news-related trading volatility. Above all, successful investing requires a long-term perspective.

*How Economic News Moves Markets by Leonardo Bartolini, Linda Goldberg, and Adam Sacarny, in Federal Reserve Bank of New York, Current Issues in Economics and Finance, Volume 14, Number 6, August 2008.

Lisa Shelton is a financial advisor for The Lowery Shelton Group at Morgan Stanley. She can be reached at 360.992.7994. The opinions expressed in this column are solely of the author’s and do not necessarily reflect those of Morgan Stanley. This disclaimer is continued on www.vbjusa.com.