The question of what should be done on negative events has been the focus of finance research for years. The impact of news or announcement effects has been the bread and butter of empirical finance for years. Clearly the adage from Wall Street is to be a buyer when others are in panic.
Behavioral finance research has suggested that being a buyer on bad news will provide positive gains because buyers must be compensated with a higher risk premium to entice the purchase of an asset. There is a risk premium with negative news uncertainty. Hence, there will an price over-reaction on the downside when there is bad news. When there is good news, there is no added risk premium needed in the market. The data suggests that there is under-reaction to good news and suggests that there will be carry-over with good information.
Under both cases there will be increases in uncertainty which will affect market prices and volatility. However, selling require overt action while holding existing assets is a passive activity. Recent research on airline crashes and stock reaction shows that the loss of market value is much greater than the ultimate settlement and cost of a crash. Hence, there is a market over-reaction.
How does this relate to the Japanese earthquake? The initial reaction was a strong sell-off and then a rally to reverse some of the losses. The theory concerning negative news would say that this is consistent with past research on bad news events. We would agree, but would like to add a slightly different twist to the story. It was not so much that bad news was the main cause of the stock decline but uncertainty concerning the news. Since it was not clear what was the extent of the bad news, it is important to be a seller until there was clarity concerning the size of loses.
Still, employing a trading strategy of buying bad news dips is dangerous. When do you buy? Does the market have to be down 2%, 5%, 10%? It is not clear. In hindsight, the answer is easy. The market reversed, so the over-reaction was realized. It is unclear that after negative news there is subsequent good news to reverse the move.
Yes, the buy dips strategy work, but it takes courage to employ capital when there is blood in the streets.
Behavioral finance research has suggested that being a buyer on bad news will provide positive gains because buyers must be compensated with a higher risk premium to entice the purchase of an asset. There is a risk premium with negative news uncertainty. Hence, there will an price over-reaction on the downside when there is bad news. When there is good news, there is no added risk premium needed in the market. The data suggests that there is under-reaction to good news and suggests that there will be carry-over with good information.
Under both cases there will be increases in uncertainty which will affect market prices and volatility. However, selling require overt action while holding existing assets is a passive activity. Recent research on airline crashes and stock reaction shows that the loss of market value is much greater than the ultimate settlement and cost of a crash. Hence, there is a market over-reaction.
How does this relate to the Japanese earthquake? The initial reaction was a strong sell-off and then a rally to reverse some of the losses. The theory concerning negative news would say that this is consistent with past research on bad news events. We would agree, but would like to add a slightly different twist to the story. It was not so much that bad news was the main cause of the stock decline but uncertainty concerning the news. Since it was not clear what was the extent of the bad news, it is important to be a seller until there was clarity concerning the size of loses.
Still, employing a trading strategy of buying bad news dips is dangerous. When do you buy? Does the market have to be down 2%, 5%, 10%? It is not clear. In hindsight, the answer is easy. The market reversed, so the over-reaction was realized. It is unclear that after negative news there is subsequent good news to reverse the move.
Yes, the buy dips strategy work, but it takes courage to employ capital when there is blood in the streets.
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