Rumors in Financial Markets: Insights into Behavioral Finance

Rumors in Financial Markets provides a fresh insight to the topic, combining the theory of Behavioral Finance with that of Experimental Finance–a new and innovative scientific method which observes real decision makers in a controlled, clearly structured environment. Using the results from surveys and experiments, the author argues that rumors in the context of financial markets are built on three cornerstones: Finance, Psychology and Sociology. The book provides insights into how rumors evolve, spread and are traded on and provides explanations as to why volatility rockets, strong price movements, herding behavior for example, occur for apparently no good reason.

Introduction:

A rumor can be everywhere, at any time, at any place. It is perceived as something mysterious, almost magical. A rumor frequently produces a hypnotic effect. It fascinates, overwhelms, entraps and stirs up people’s minds. Rumors are the oldest mass medium in the world and their nature is still difficult to grasp. What is so special about rumors, that people get so excited, anxious and nervous? Why do companies release press bulletins stating, ‘We don’t comment on rumors’? People do not know too much about this important social phenomenon, especially from a scientific point of view. Where does it start, how does it develop, where and when does it end? How does it differentiate itself from gossip, legends and just ordinary information? How are rumors spread, when are they believed and what kind of an impact can they have?

Everyone believes they are able to recognize a rumor when they are faced with one, but no one can give you a satisfying definition of it. The longer people think about rumors, the more they realize how difficult it is to set limits on what they are and what they are not. Why is it so difficult to capture the exact content and functionalities of a rumor?There are at least two possible explanations for that. The first explanation is that a rumor is not observable from the beginning to the end. When people start studying a rumor, it is usually already dead or in the final phase. In many cases it will be very difficult to find out its starting point and development process. The second possible explanation is that rumors, at least until a few years ago, have included a moral aspect. This prejudice has made people think more about the moral entitlement of a rumor than of actual functionalities.

One of the most central elements of the Theory of Finance is the economics of information and how new information is updated to reallocate scarce resources. Rumors are a special form of information and their special characteristics have to be accounted for when applied to the Theory of Finance. Since rumors involve not only financial but also psychological and sociological elements, it is necessary to apply an interdisciplinary approach when analyzing rumors in financial markets. While the individual behavior when faced with rumors in financial markets is one aspect to be analyzed, probably the more interesting one is to search for behavioral mechanisms on an aggregate level. One of the goals of this work is to evaluate whether rumors lead to systematic behavioral patterns when trading assets in a financial market.

Unfortunately, from a scientific view, not too much is known about rumors, in particular in financial markets. This is somewhat astonishing, since rumors on the one hand have a very long history and are known to be a very efficient mass media communication channel, and on the other hand appear almost on a daily basis in technical newspapers and magazines. One of the difficulties about research on rumors is their complexity in nature. A second argument for the poor research so far can be found in the difficulty of gathering sound quality data on rumors, in particular in financial markets. This work is an attempt to gain more insights into the topic.

The overall aim of the book is to provide insights into various aspects of rumors in financial markets. How can this be achieved? Since the subject is not easy to address and just about everyone has a different opinion on it, first of all it has to be clarified what exactly a rumor is and how it fits into other notions such as information, news and gossip. Secondly, since this is an investigation on rumors in financial markets, rumors have to be set in context to the existing finance literature. This includes aspects such as how rumors, as a quite special form of information, are used to allocate scarce resources from a Behavioral Finance point of view. In addition, many people claim that market participants act irrationally when rumors evolve in financial markets. This question has to be addressed as well. Furthermore, since rumors, in particular in relation to financial markets, are at the edge of being legal, the aspects of insider trading and market manipulation have to be clarified as well.

However, to really get more insights on the topic, further research is necessary. As a first step, a survey was conducted in the financial marketplace to find out what the questions and hot topics are that market participants are faced with when rumors evolve. From the results of the survey, it became clear that certain aspects discussed were not very relevant to further analysis, while with other aspects more questions seem to have arisen than been clarified. The next step was to analyze the most suitable research methodology to try and answer these open questions. Research methodologies such as theoretical modeling, empirical analysis, field studies and experiments were considered. A review of that literature is discussed in Chapters 3 and 6.

In the end, the choice fell on conducting financial experiments, for many reasons. The detailed arguments in favor of that research methodology are discussed at the beginning of Chapter 6. The overall goal of those financial experiments was to gain insights on why we observe what we observe when rumors evolve in financial markets. Why is it that stock prices all of a sudden perform wild swings, volatility rockets to the sky and market participants simply shake their heads because they aren’t able to explain what is going on? Exactly these kind of questions the experiments try to find an answer for and discover what is going on in people’s minds and whether there are any theoretically sound explanations for these phenomena. Therefore that chapter of this book is more devoted to theory and describes the financial experimental setup and results of the experiments conducted. The conclusions of all the results are drawn in Chapter 7, what open issues still remain and what kind of future research could be performed to better understand the fascinating happenings in financial markets, in particular when rumors appear.

Contents:

• Definitions and Characteristics of Rumors
• Rumors and the Theory of Finance
• Legal Aspects of Rumors in Financial Markets
• Survey of Rumors in Financial Markets
• Rumor Experiments
• Conclusions and Outlook

Rumors in Financial Markets: Insights into Behavioral Finance By Mark Schindler pdf