A study involving the Cluster of Excellence ECONtribute at the Universities of Bonn and Cologne suggests that people often interpret stock market opportunities differently from what standard financial models predict. This pattern is found not only among retail investors but also among financial professionals. The study, “Mental Models of the Stock Market,” was published in the Quarterly Journal of Economics.

Consider a company announcing that it expects to reduce its production costs by 20 per cent. Even if the announcement was made four weeks ago, many investors may still see it as a reason to buy the company’s shares. They assume that lower costs will lead to higher future profits and, in turn, better investment returns.

Standard financial models, however, suggest otherwise. Stock prices generally react quickly to new information. By the time four weeks have passed, positive news about lower production costs should already be reflected in the company’s share price. Investors buying the stock later would therefore be paying a higher price and should not expect additional returns simply because of the earlier announcement.

“When a company announces some good news, many people take this primarily to mean the company’s earnings prospects have improved,” explains Johannes Wohlfart, professor at the University of Cologne and a member of ECONtribute. What investors may overlook is that other market participants have received the same information and that the share price may already have adjusted accordingly.

To examine how people think about such situations, Wohlfart and fellow economists Peter Andre of Goethe University Frankfurt and Philipp Schirmer of the University of Bonn surveyed more than 7,000 people in the United States and Germany. Participants included members of the general public, retail investors, financial advisers, fund managers and financial market researchers.

Participants were presented with two scenarios involving company announcements that were already four weeks old. In one scenario, a company announced a reduction in production costs, representing positive news. In the other, the company announced that it was maintaining a supplier partnership, which was considered neutral news. Participants were then asked how they expected these announcements to affect future stock returns.

The findings revealed substantial differences in how participants interpreted the same information. After receiving the positive news, 60 per cent of the German general public and 74 per cent of German retail investors still expected higher future returns. Similar expectations were reported by 58 per cent of fund managers and 63 per cent of financial advisers. In contrast, 67 per cent of financial market researchers expected the old news not to affect future returns.

The researchers suggest that these differences reflect contrasting “mental models” of how the stock market works. Financial market researchers tend to consider both a company’s future profits and its current share price, consistent with the idea that markets rapidly incorporate new information. Retail investors, by comparison, often focus more heavily on future earnings while overlooking the price they must pay for the shares. As Schirmer explains, investors may correctly recognise that a company could become more profitable but fail to consider that its share price has already risen in response to that expectation.

More information: Peter Andre et al, Mental Models of the Stock Market, The Quarterly Journal of Economics. DOI: 10.1093/qje/qjag039

Journal information: The Quarterly Journal of Economics Provided by University of Cologne