Rumours run the market
Every day we hear or read about companies being interested in buying other companies or announcing stock splits. These rumours are usually considered positively by investors and stocks rally. In the same fashion, when bad rumours spread, for example about earnings announcement below expectations, stock prices usually take a big hit. And this is just at the company level. At the macro level, just think how monetary policy, fiscal stimulus announcements, important economic data releases can create a buzz among investors. Here we can pick various examples: surging covid cases creates the expectations on new lockdown which have negative impact on the oil price but also how the US curve was pricing seven interest rate hikes when actually no official announcement had been made.
People try to anticipate the outcomes of these events and the impact of the same on security prices. Surely having insider information helps you beat other investors, but that is “insider trading”. Still, there is a strategy, following the seasoned behaviour among traders: “Buy on rumours, sell on news”, that tends to profit from “regular” rumours thanks to a particular investors’ behaviour, that is they tend to buy in the days and weeks leading up to an event that is supposed to be favourable for the security in question.
“Buy on rumours, sell on news” …in 1688
Yes, that is not a typo, the first instance of this investors’ behaviour trace back to the late 1600’s and is reported on the book “Confusion de Confusiones”, written by Joseph De La Vega, which is the first study (we have a record of) that documents investor biases and is thus a clear precursor of the current behavioural finance literature.
De La Vega’s work has been widely studied from different points of view. In fact, being a merchant in diamonds, financial expert, moral philosopher and poet, he wrote about diverse subjects. “Confusion de Confusiones” was a consequence of his financial experience. This is the first and oldest book about the stock exchange and even today is a good description of financial transaction.
In the book, he writes, “The expectation of an event creates a much deeper impression upon the exchange than the event itself. When large dividends or rich imports are expected, shares will rise in price; but if the expectation becomes a reality, the shares often fall.”
A behavioural perspective on this phenomenon
If we analyse the dynamic that allows this phenomenon to exist and be profitable, we can clearly see four well-known biases: “Impact bias”, “Narrative”, “Herding” and “Myopic Discounting”. Let us analyse them one by one and see how they contribute to the phenomenon:
- Impact bias: The tendency to overestimate the intensity or the duration of future emotions and state of feeling, which brings investor to overestimate the impact of the “news”, that is, when the news becomes official.
- Narrative: Following the expectation of a positive outcome, the rumour attracts a certain attention leading to a positive narrative.
- Herding: It is just the follow up of the previous points since investors want a piece of the cake because they are attracted by the narrative.
- Myopic Discounting: It refers to the tendency of attributing greater weights to near-term rewards over longer term ones. As a result, investors pile up and reinforce the trends, because they downplay the risk.
Therefore, by the time the official news is released, nearly anyone who wanted to trade on the rumours is already positioned, hence there are few investors further continuing the upside movement. When the event is done with and the outcome is as per expectations, the trend starts reversing, risk taking shifts to risk aversion, leading people to sell, trying to cash in their profit.
Stock split and earnings announcement
As said in the first paragraph, stock splits are one of the various events which confirm the effectiveness of the strategy, since they are a way to attract investors thanks to the reduced price, even though nothing has fundamentally changed in the company.
As mentioned in the first paragraph, stock splits are one of the various events which confirm the effectiveness of the strategy, since they are a way to attract investors thanks to the reduced price, even though nothing has fundamentally changed in the company. Consider, for example, the recent Apple stock split in 2020. Apple’s stock price rose more than 40% in the month leading up to the day of the stock split (Aug. 31st). Analysts and traders were buzzing about how the split would help fuel the price higher, and as investors piled in, by the time the stock split happened, everyone who wanted to own it was on board. Over the three weeks following the split, the stock fell more than 20%.
The other well-known instance is earning reports. Let us consider Apple again since it is well known and liquid. During the first three earning releases of 2021, as traders expected that Apple would post good earnings, the stock rose in the month leading up to the announcements. This was buying the rumour, and it worked since earning results exceeded estimates. And yet the price fell right after earnings.
In conclusion, when employing this strategy, a trader buys because the expectation about the future announcement or data is positive. This is due to the biases seen above. The strategy then implies to sell when the actual news is publicly available. However, there is still the possibility to further upsides thanks to the positive news luring in additional buyers.
Corzo, Prat & Vaquero, (2014), Behavioral Finance in Joseph de la Vega’s Confusion de Confusiones, Journal of Behavioural Finance, 15:4, 341-350
Chandan N., (2021), “Why ‘buy on rumours, sell on news’ almost always works in stocks”, Indian Economic Times
“Buy the rumour, sell the news strategy explained”, CMC Markets, https://www.cmcmarkets.com/en-gb/trading-guides/buy-the-rumour-sell-the-news