Investment Research Group
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The good news – and the bad – is that it is not strictly the fault of those people who invested in the finance company turkeys. The brains of human beings, for better or worse, are essentially wired to have a large degree of confidence in their abilities.
Unfortunately, such confidence often can lead to hubris, especially where investment is concerned. That’s why so many so many investors tend to take outrageous risks with their money, especially during the good times.
A study of share markets by Exeter University in the UK has found that individuals put too much emphasis on recent trends in the data and too little on the wider scenarios.
In other words, people tend to move between thinking that ‘things will get back to normal soon’ and the position that ‘these good times will last forever’.
In a study of companies that come out with a profit warning, the researchers found that prices of their shares often did not slump on the news in the short-term.
That’s because investors were sticking with ‘things will get better soon’ mentality.
However, if further bad news comes out, eventually investors switch to ‘recent declines will continue’ and the price plummets.
Then the negative attitude holds fast until the company comes out with some unexpectedly good news and prices rebound strongly as everyone switches back to the ‘good times’ theory.
After studying 455 UK companies that put out profit warnings, Exeter says the average company loses 16.6% of its share value on the day of a seriously negative announcement.
Over the following six months, by when the earnings announcement has been made and people are operating on facts rather than fears, the average decline is a relatively modest 3.9%.
After one year, when signals start emerging about the next year’s profits, many companies show that the previous year’s decline was a one-off. Their prices recover strongly, with daily gains that are 23% higher than the market average.
In terms of a “life cycle” of stock pricing the researchers say the market starts to get an indication of a bad earnings result approximately two years before the warning.
In other words, if a share starts declining for no apparent reason – sell at least some of it, just in case.
The trick for investors is to determine which companies are in a long-term decline and which are merely having a bad moment and will recover.
The latter make good investments because most other investors will have switched to ‘all is doom’ thinking therefore the shares will be at bargain basement levels.
