Financial Markets as Prone to Rumors

financial markets

Rumors can be a means of social control to help some individuals, a group, an organization or an institution to achieve a certain objective.  In this case, a rumor can be an instrument of various groups, business organizations, political parties and other institutions to fight in order to achieve the interests. Thus, rumor has an instrumental purpose. It can become an effective means of control of social groups and social behavior as well as a means of support to a group’s identity and stability (Valdas, 2009). They also give a sense of control for traders in unpredictable financial markets.

“It’s really just a combination of illiquidity, the usual rumors about some firm on the verge of collapse, and the holiday,” a trader at a Western securities company in Tokyo said. The rumors of hedge- fund trouble are “nothing that I can substantiate, just smoke and mirrors, but it sends people running for cover where they can. The market’s extremely illiquid and subject to wild swings on the thinnest of rumors (Arnold, 2008).”

“Rumors can be viewed as a substitute for news.  When there is a lack of news in financial markets, future projections are created to fill in gaps of information.  When these projections are communicated within the investing community, a rumor is born.  This is the classic way in which rumors are created.  (Schindler, 2007). For example, if a CEO says that their company is interested in merging with another, but does not designate with whom, rumors may develop.  These substitutes for news will evolve and spread throughout the market if the information they provide is stimulating and of major importance.  According to Schindler (2007), there are two ways in which rumors are analyzed by behavioral finance.  One is at the individual level in which the procedure is taken to make an investment decision is analyzed.  The other is the aggregate or market level which focuses on how irrational behaviors by investors lead to disproving the Efficient Market Hypothesis” (Karasidis, p.5).

market

Schindler (2007,) explained why financial markets are susceptible to rumors. All actions on the trading floors are based on news. Getting information is crucial in gaining profit for traders in financial markets. In the absence of real information about the market, traders often grab any improvised news or rumors to guide their trading decisions. Since time is of the essence and traders are always in pressure to make swift financial decisions, verifying the truthfulness of financial rumors proved to be difficult. Thus, traders tend to take rumors as news. Owing to the lack of time, their only concern is the reliability of the source of rumors and not for their content. Since they are under pressure to trade to earn a profit, traders oftentimes grab rumors as news. If he doesn’t trade, he loses money if the rumors turn out to be true (Schindler, 2005, 19).

A study by Werner and Murray (2004) confirmed the influence of rumors in the market. It showed that a positive rumor usually leads to a positive return on the following trading day, while a negative message leads to a negative return on the following trading day. Another study by Kiymaz (2001), examining good and bad rumors, also showed that  good rumors on the market generate abnormal returns beginning four days before their publication, while the effect of negative rumors begins only after publication. Wysocki (1999) also found increasing returns and trade values the day following the rumor, especially when it is published at night while markets are closed.

Photo credit: Shutterstock

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