Why Investing in Stocks in the Headlines Is Not a Good Idea

Don't Invest in Stocks Making HeadlinesBehavioral finance research has shown that individual investors too often invest in  stocks that are in the news, and that those stocks then lose money.  A recent story in the New York Times illustrates why this may become an even less successful stock investing strategy: program traders are beating average investors to the punch.

Buy Stocks in the News, Lose Money

Investors are attracted to stocks of companies in the headlines. One study found that when Maria Bartiromo mentions a stock during the Midday Call on CNBC, volume in the stock increases nearly fivefold (on average) in the following minutes. That would be ok if the stock then went up, but generally, it goes down instead.

Berkeley Professor Terrance Odean parsed the trading records of investors at a large discount brokerage firm, and found that the stocks investors bought underperformed those that they sold.  And in subsequent research he and Brad M. Barber, of the University of California, Davis, find that individual investors are net buyers of attention grabbing stocks ( stocks in the news, stocks experiencing high abnormal trading volume, and stocks with extreme one day returns.) They argue that stems from the overwhelming challenging of picking a stock from the tens of thousands on offer. When it comes time to sell, the authors note, investors don’t face that same challenge. They only have a few existing holdings to chose from.

This is a global phenomenon. Mark Seasholes, then a professor at Berkeley, and Guojun Wu of the University of Houston, found that individual investors on the Shanghai Stock Exchange were also big buyers of stocks gaining attention in this case for hitting an upper limit. Even first time stock buyers were more attracted to this group. Unfortunately for all, the stocks subsequently returned to more normal (lower) levels.)

The speed and decreasing cost of trading makes it even easier for an investor to be tempted to buy a glittering stock as Odean and Barber term them. One online brokerage has created a product that allows you to buy a stock as you read about it on popular news sites.

Program Trading on the News

In “Computers That Trade on the News” Graham Bowley reports that linguistics-based software may be creating a new kind of digital divide: between those with computers sophisticated and  fast enough to sift through a flood of information, and trade  on it instantly,  and the rest of us:

The development goes far beyond standard digital fare like most-read and e-mailed lists. In some cases, the computers are actually parsing writers’ words, sentence structure, even the odd emoticon. A wink and a smile — 😉 — for instance, just might mean things are looking up for the markets. Then, often without human intervention, the programs are interpreting that news and trading on it.

Given the volatility in the markets and concern that computerized trading exaggerates the ups and downs, the notion that Wall Street is engineering news-bots might sound like an investor’s nightmare.

But the development, years in the making, is part of the technological revolution that is reshaping Wall Street. In a business where information is the most valuable commodity, traders with the smartest, fastest computers can outfox and outmaneuver rivals.

Bowley quotes one investor describing the scramble for this information as “an arms race.”

But that’s a race retail investors can’t win.

*****

photo: Stefano Corso

9 thoughts on “Why Investing in Stocks in the Headlines Is Not a Good Idea

  1. Zack

    Good article. Like the attraction to hot money in ETFs and mutual funds, investors are attracted to popular stocks. But aren’t you saying two things in this article? One, investors typically lose by investing in media darlings but that there is an arms race to get better/faster tools to do just that?

    I guess with more data/semantic analysis, those who win the arms race will be able to sift through the noise.

  2. Nanette Byrnes Post author

    Excellent point — why would millions be poured into programs examining the news if there wasn’t a payoff? Your idea may be right — that they’re figuring out a way to sift through the noise. But I wonder if the difference is more about the time horizon of the investor. The program traders are moving in and out of investments at a truly incredible clip. So if they know that there’s a temptation for people to invest on the news, and they can get ahead of that through technology, they’ll grab that advantage. For individual investors who cannot begin to hope to move at that speed, there’s little chance of matching them at that game, and little reason to think they’ll fare differently from the unfortunate investors in the academic studies.

  3. Matt SF

    Good post. This is why I say it’s better to stick with companies with a solid reputation (real or perceived), so long as their reputation can’t be tarnished or stock holders don’t suddenly lose faith.

    In other words, the perception of the herd and the ability to “sell” the hope in a stock is far more persuasive an argument than the actual fundamentals. (Of course, this is a trader’s mentality rather an a buy & hold investor.)

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