Media and the Stock Market

New research by the Univerity of Warwick investigates the influence of news publications (in this case the UK's Financial Times) on the stock market, and finds that a write up in a newspaper directly impacts trading volume of the stock the next day. The abstract:

Here, we exploit a large corpus of daily print issues of the Financial Times from 2nd January 2007 until 31st December 2012 to quantify the relationship between decisions taken in financial markets and developments in financial news. We find a positive correlation between the daily number of mentions of a company in the Financial Times and the daily transaction volume of a company's stock both on the day before the news is released, and on the same day as the news is released. Our results provide quantitative support for the suggestion that movements in financial markets and movements in financial news are intrinsically interlinked.

What is especially interesting is the time lapse between digital publication, print publication and a discernible change in the market. The research showed that the greatest impact rested from the print publication, not when written up online. John Authers, FT columnist looked at the research and noted: "the news continued to have an impact on the next day. As there are now many sources that should move markets more swiftly than a printed newspaper, this also implies that it was the news itself, rather than any editorial choice about publishing stories, that moved prices."  

To me, the main message is about market efficiency, and the fact there isn't any. Well some, but it is a weak form. Market efficiency, of course, suggests that markets take in all the information and prices adjust. Here, the lapse between publishing a story and the market impact suggests (for starters) that not everyone is aware at the same time. This suggests, however, that momentum trading strategies based on publication digital and print publication time differences, may produce a higher return.  

Already, many are starting to take advantage of this trading strategy based on social media trends. But, lets not forget that news agencies are often the ones to break the story, which is then propagated through other media forms. 

Next steps? Look at whether the sentiment of the article influenced trading direction. This has certainly been true in studies of google searches, and social media, which have been showed to correlate with trading direction. Is this also the case with the "neutral" news? Also, is this true of other organisations? Do less financial based news companies have less of an impact? What about broadcasting houses who comment on the markets? What about parts of the world with moderated/controlled media?

Further reading:

Choice overload and financial instruments

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Financial instruments should be more carefully scrutinized before entering the market. Similarly, risk should be portrayed comprehensibly (and comprehensively) to investors.

If individuals behaved rationally, they would seek to enhance their welfare. They would invest and hold a portfolio of assets that met their allowable risk-return trade offs  and was consistent with investment horizon and needs. Unfortunately, this is rarely the case. Indeed, “behavioural economists and empirical researches have shown that in reality members are not particularly good at handling their retirement savings, either because they lack the necessary cognitive ability to solve the optimization problem, because they have insufficient will power to execute it, or even sometimes because they are overconfident.”

Extrapolating from the above article, one can assume that people are making sub optimal choices in their investments. Additionally, evidence suggests that the number of choices available amplifies these facts and “induce a preference for simpler, rather than less risky, options”.

The most likely candidate to address issues around choice overload, poor comprehension and the resulting obtainment of risky assets is the pubic sector. While private sector companies, such as S&P and Fitch have attempted to create evaluative mechanisms, they have failed. Since the crisis, rating institutions have been critiqued for lack of impartiality. Seemingly, a “cosy” relationship existed between rating agencies and banks during the crisis; “many financial experts believe that overly optimistic assessments by ratings firms were a key factor in creating an overblown market for derivatives and mortgage-backed securities.”

If, however, a public sector entity were able to evaluate instruments, and relay this information to the public, a more robust financial system would result. Less risky assets would be on the market, and comprehension would be improved.

Not only would investors be making better decisions, from better choices, but they would also be happier about it. While particularly cloying, it seems that that the mere “presence of categories, irrespective of their content, positively influences the satisfaction of choosers who are unfamiliar with the choice domain.”

When framed like this, it suggests that presenting choices in a better way – where options are relevant to investment goals, and are not too numerous or complex – will result in a type of self-fulfilling prophecy whereby motivation, learning and well-being are enhanced.

 

 

 

 

 

The psychology of executive remuneration

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Executive pay across industries is facing criticism surrounding high salaries. This condemnation is especially true in the financial services, both in wake of the financial crisis and in light of an increase in their share of the wage bill. Indeed, the pay gap in the UK has widened significantly over the past thirty years. Someone in the 90th percentile in 1979 earned 2.5 times more than someone in the 10th percentile, now he earns 3.7 times more. 60% of the increase among the top 10% of earners is accrued to those working in the financial sector.

Much of this increase takes the form of a bonus. Originally, bonuses (performance pay) were designed to align the incentives of the executive with that of shareholders. It was meant to eliminate the principal-agent problem by aligning executive incentives to increasing company value. By reaching a certain benchmark, executives were given additional remuneration. This bonus was often given in the form of stock options or shares, which was meant to further goal alignment. Yet, this has not necessarily worked as meant. Performance pay has led executives to take unnecessary risks. Bonuses have been continuously paid even when institutions are failing. Salaries became a way for executives to judge themselves against their peers, rather than used as a judgment of company performance. 

There are two main problems with this theory, however. One stems from an incorrect view of human motivation. The second problem is associated with payment relativity.

Money is not the only motivation for workers. While bonuses have long been used to incentivize performance, large bonuses when performing cognitive tasks are actually counter-productive to performance. Research has shown that while financial incentives can motivate people to work, very large bonuses can hinder performance by causing stress involved in attaining it, the fear of not receiving the bonus and focusing attention on the bonus rather than the job at hand. 

The problem of compensation relativity is two fold. First of all, executives judge themselves against one another, and compete for highest salary. This leads to higher compensation demands, without the performance to back it up; meaning there is sometimes inconsistency between economic value added and pay. Payment relativity is also problematic when peer group comparisons are used to determine pay. Pay groupings are meant to provide information on appropriate salaries, providing boards with benchmarks, but often result in the inflation of executive compensation when peer groups with higher salaries are chosen. 

A third issue surrounding performance surrounds the idea of crowding out. Monetary incentives have been found to impact the intrinsic motivation of people, as motivation now comes from something external. As a result, people perform less well after monetary incentives are given. This is true regardless of the form of the remuneration (base pay versus bonus).

The regulation of executive compensation is an area currently being considered by regulators, central bankers and more. While regulators are focusing on the structure of pay packages from an economic perspective, they must also be careful to consider the psychology and utility of remuneration before altering the structure of executive payment. 

Trusting the financial markets

Former Bank of Canada governor, David Doge, said trust “is more than a simple belief in something or someone without supporting evidence. Trust is what develops when a group of people share an understanding that the rules for behaviour governing their system or society work well and make things better for everyone.” 

Unfortunately, this shared understanding of rules and behaviour is seemingly missing in financial services. According to the Edelman trust barometer (2012), a yearly survey monitoring public trust in institutions, only 40% of people trust banks. Trust in the more general “financial institutions” sits only slightly higher at 45%.

Trust is not a unitary concept, however.  There are many forms of trust, and the various forms are malleable. All follow the basic premis that an agent will act in a consumers best interest. But, problems of performance based executive compensation, commission fees and a focus on short-terminism means this is rarely the case. 

A loss of trust in financial services is problematic for several reasons. Trust helps the functioning of the financial system, which positively impacts the real economy. With trust, less effort is expended on “keeping tabs, so systems can run more efficiently,” and transaction costs are reduced.  There is less of a chance of bank runs and capital is allocated more efficiently.

While all three forms of trust can and have been broken in recent history, the most common breach of trust occurs in an agency relationship. An agency relationship is a contract where “one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf, which involves delegating some decision making authority to the agent.”  Unfortunately, “there is a good reason to believe the agent will not always act in the best interest of the principle,” if both parties are utility maximizers.1

Agents in financial firms are particularly well placed to maximize their own utility because of asymmetric information, moral hazard and complexity inherent in the financial system. In fact, financial firms exist, in part, because of asymmetric information. Financial agents, be it investment advisors, fund managers or bankers, are employed to utilize this superior information on behalf of the consumer. Agency relationships are fraught with moral hazard, as the agent is not typically responsible for the costs associated with risk taking. The complexity of the financial system is, in part, is what makes agents able to maximize in this way. Together, these three issues create a severe principal-agent problem.

How can regulators help bring trust back into financial services? You can’t, really. Trust develops slowly but surely over time. But, here are some recommendations to develop and maintain trust into the future.

  1. Increase transparency
  2. Principles over rules based regulation
  3. Increase competition in the financial sector while reducing switching costs (consider portability of account numbers)
  4. Only allow certain products that meet risk requirements
  5. Criminalise breeches of trust
  6. Increase financial literacy

Some of these are already occuring, or at least there are movements in this direction. After LIBOR, for instance, criminal charges are being levied against perpetrators. Think tanks and educational instituitions are attempting to encourage literacy. But, its not enough.