E-motions: Vol. No. 1, Issue No. 3, August 8, 2005

Loss-averse Investors Won't Always Act Fast on Negative News

1. Emotions in Focus: Loss Aversion
     Fear of loss may be the only human emotion more potent on the market than simple greed. When presented with a gain and a loss of equal value, people do not respond with the same intensity to each. People are loss averse. Psychologists and behavioral economists have shown that people would rather avoid losing $10, than have the chance to win $20. Arguably, the desire to maintain what one has and subsist may be the only market force more powerful than greed. How this universal aversion to loss manifests itself in the stock market is twofold. First of all, negative news, sparking fears of loss on the market may not translate into lower stock prices as directly as positive news translates into higher stock prices. When negative news does lead to a stock going down in value, however, that drop is usually much larger than the respective increase associated with positive news. While rationally, investors should be just as emotionally involved in making a $10 gain as preventing a $10 loss, there are a number of explanations for this irrational loss-averse behavior, as well as for the sometimes volatile and unexpected effects of negative news on the market.
Overall, much of the irrationality we display in terms of evaluating amounts and numbers come from heuristics, or rough ways of estimating the reality of the world around us. These cognitive biases have been shown to be cross cultural and to come from very far back in our evolutionary history as means of processing large amounts of information very quickly in times where it is critical to act quickly. Nonetheless these biases appear even in the most mundane thought processes as well. Studies have shown that people are more willing to drive to the next town to save $19.99 on a cell phone than they are to save the same amount on a computer. While the total savings are the same, twenty dollars is a larger percentage of the total price of the cell phone, so the buyer feels as though he or she is saving more money. Demonstrating the cross-cultural, global nature of the phenomena, non-governmental aid organizations have reported that it is not uncommon for hungry people in the developing world who are given a kind of grain they with which they are unfamiliar to refuse to eat it, despite the threat of starvation. Furthermore, research suggests that, as a species, we may be hard wired to avoid risk, even if this conservative behavior can impede our long term chances of thriving. This premium on subsistence rather than success, demonstrated in a wide range of primate species, reflects back to a previous time where we struggled to find food and safety. Universally, loss aversion is a factor that can influence us today in the most unexpected of ways, including how we invest.

2. The Big Movers and Why: Positives and Negatives
     In past weeks MediaSentiment correlations between Heads Up thumbs up / thumbs down ratings of earnings release sentiment and stock highs and lows the following day show a consistent pattern of loss aversion on the market. Specifically, positive recommendations are slightly more accurate than negative recommendations at predicting subsequent stock price, but ultimately, when negative recommendations are accurate, which is still a vast majority of the time, they reflect larger overall changes in price. Last week, the correlation between positive Heads Up recommendations and subsequent stock highs was 78%, but the average change in percent increase in stock value was 2.37%. Meanwhile, the correlation between negative Heads Up recommendations and subsequent stock lows was less at 74%, but the average percent change in overall stock value was 2.74%, over one standard deviation higher in value. This pattern shows that investors make a more direct and obvious connection between good news and higher stock values because they only stand to make immediate gains, and losses are in the longer term and do not reflect losing previous investments. On the other hand, in the face of negative news, investor's reactions may be less direct or delayed because they want to avoid losing on what they have already invested if they think a company has a chance of going back up.
For example, last Monday, after releasing a highly positive earnings report, Administaff, Inc. (NYSE: ASF), a company specializing in providing administrative staff to other companies, went up 20% of its value by closing the next day. Meanwhile, last Friday, MDC Partners, Inc. (Nasdaq: MDCA), a company specializing in communications technology and secure electronic transfers, was down 17.24% of its total value after releasing mixed earnings reports detailing higher company costs. Both companies announced their earnings during pre-market hours, but their respective peaks and dips in price occurred with very different timing. Administaff, Inc., with positive news gained approximately 75% of its price increase immediately during pre-market trading, as investors were immediately sure the good news would equal gains for the stock. Conversely, for MDC Partners, Inc., with moderately negative news, traders waited until well into the day's open market to sell, as they were afraid to take a loss on their investment, and the company went down 75% of its loss for the day well into open market hours.

3. How to Make the Most of the News
     In order to make the best use of positive and negative news, it is helpful to realize that individuals fear taking a loss on what they have already invested in, while when they buy, they have not made a previous investment in the company and losses are in the long term rather than the short term. Therefore, comparatively speaking, positive news will lead to gains more directly and quickly than negative news will lead to losses. Instead, investors often wait to act on negative news, hoping to establish whether or not the stock will go down in price significantly or bounce back up. Ultimately, they fear selling low, taking a loss, and then having the price come back up after their decision. In fact, if news about a company is 60% negative and 40% positive, investors will often pay disproportionate attention to the good part of the news if they stand to take a loss on selling their investment.
Significant movement on negative news will then often come later, once a tipping point has been reached where it is clear a vast majority of investors have stopped watching and waiting and now want to sell on the news. Then the price quickly drops as everyone decides to sell. This price drop on bad news will usually be larger than the price increase associated with parallel good news. As an investor, it can be very helpful to understand the timing of market dips on negative news as relative to increases on positive news so you can beat the crowd before they form a consensus of fear and force a stock price down.

4. Last Week in Media Sentiment
     Last week's correlations between MediaSentiment.com's thumbs up / thumbs down recommendations for Heads Up rated companies and subsequent stock price show a powerful relationship. The correlation between ratings for MediaSentiment.com selected stocks and their highs and lows the next day is 75%, explaining a majority of the variation in highs and lows. Therefore, this week, MediaSentiment gave a 75% edge to smart investors who used Heads Up recommendations!
All figures reflect all MediaSentiment Heads Up recommendations for the week of August 1, 2005 through August 5, 2005, rating companies on the day of their quarterly earnings releases correlated with their stock highs, lows, closing prices and daily volumes for the subsequent day.

5. Links You Can Use

Loss Aversion: What is It?

Human Loss Aversion Behavior is Mirrored in Monkeys

Loss Aversion and Stock Prices

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