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Wednesday, February 21, 2007

Information asymmetry - Chetan Parikh


In a great book "Wallstreet on sale", the author, Timothy P. Vick, writes about information asymmetry.


“Information forms the lifeblood of investors. No matter how polished your analytical skills may be, you must possess timely, objective, and useful information to score successes in the market. The efficient market hypothesis assumes that every market participant has equal access to information and has the ability to screen it accurately and interpret it correctly. But if asymmetry exists, that is, if some investors possess more, or better, information that others, or if that information proves incorrect, then the concept of efficiency breaks down.

In outlining the case against efficient markets, we conclude by noting that most information comes to us in a highly tainted form and has a great bearing on the direction of stock prices. Since most information on which we trade contains some form of “spin,” the possibility always exists that our reaction to that information proves erroneous. To advance my case, I offer three suppositions:

Information is not universally available. The cost to obtain adequate sources of information handicaps most investors. Even today, when millions of investors have access via the Internet to what was once guarded information, they lack access to the types of information that can impact a stock in the near term. Investors cannot visit companies regularly, speak with trade associations, suppliers, distributors, or sit in on conference calls with management.

No two people interpret information identically. We form our interpretations depending on our perspectives. As shown in the Exxon example earlier, investors trade based on their own financial needs, goals, limitations, access to news, and interpretation of events. Like the weather, we tend to view information in relative terms and from a current context. A 60-degree day in spring feels downright balmy after weeks of 30-degree days. The same 60-degree day in summer, on the heels of 80-degree days, would cause a chill in you. Likewise, a stock that rallies to $60 often seems a better buy than one that falls to $60 often seems a better buy than one that falls to $60, though an investor should be indifferent to both circumstances.

Information is usually spoon-fed to investors by people who want to influence the interpretation. We cannot underestimate the role that Wall Street, the media, and newsmakers play in shaping our opinions and our decisions to invest. Any information that is filtered, and that includes about all that the financial industry generates, creates the potential for price inefficiency. Wall Street twists information innumerable ways: by issuing price targets on stocks, for example, estimating earnings in advance, leaking rumors of takeovers, or upgrading or downgrading companies for the flimsiest of reasons.

The media’s desire to win subscribers leads reporters to generate news where none might exist, trumpet hot stocks after their best rallies have passed, or deluge you with articles like “The Top 10 Funds to Buy Now.” The vast majority of investors attain their market information secondhand, usually through the media. Thus, they are exposed to the spins and biases already built into news stories. A reporter can severely distort information even with the tone she takes in composing an article. A misleading headline or a reporter’s desire to sensationalize a trivial news occurrence can disrupt supply and demand for a stock. Consider the media frenzy created in 1995 when Intel discovered a minor flaw in its Pentium chips. The story first broke over the Internet when spreadsheet users complained to one another that some of their computer calculations were incorrect. Once a reporter discovered the controversy, the Pentium story quickly became the media’s crisis of the week. Intel’s stock fell sharply as the company devoted considerable time to fending off public criticism. No sooner had the story appeared than it disappeared from the front pages, but not before thousands of investors sold their shares and the market value of Intel’s stock dropped by more than $6 billion. Here, investors’ optimism over Intel’s prospects suddenly turned to pessimism on the basis of trumped-up stories of little significance to Intel’s long-term fundamental outlook. Intel quickly recalled the chips, took a quarterly charge against earnings, and put the issue behind it. The stock tripled in price over the next two years.

Investors who are wont to trade based on information are particularly vulnerable to interpretation bias. A favorite example of mine occurred on January 22, 1997, when major media outlets tried to interpret Federal Reserve Chairman Alan Greenspan’s remarks before the Senate Budget Committee. Depending on which news story you read the following day, inflation either was rising or holding steady; the economy either was growing nicely or in danger of overheating; and reporters either was growing nicely or in danger of overheating; and reporters either were trying to sway your viewpoint or didn’t know what to say.

Consider just five of the headlines boiling down Greenspan’s testimony that day:

  • “Fed Chairman Sees a Pickup in Wages,” reported The Wall Street Journal. The article said Greenspan hinted he would hike interest rates.

  • “Greenspan Upbeat on Economy, Issues Wage Warning,” read a headline by Reuters. According to the wire story, Greenspan was satisfied with the pace of economic growth and “gave little indication” the Fed was preparing to raise interest rates.

  • “Greenspan Upbeat on Economy,” ran The New York Times. “But he warns of pay gains,” amended the story. “Testimony rallies market.”

  • “Greenspan Warns of Inflation,” read the slug line to a story the Associated Press wired to member newspapers.

  • “Fed Pleased but Puzzled,” announced CNN’s financial news network.

If you were unable to hear Greenspan’s unfiltered testimony on cable television, your interpretation of his comments were formed based on what news service you happened on that day. If you picked up the newspaper one morning and the headline read, “Fed Chairman Hints of a Rate Hike,” you might try to protect your rate-sensitive stocks by selling shares. But if the newspaper, recounting the same testimony, used the headline, “Fed Comfortable with Current Rates,” you might feel relieved and compelled to do nothing.

Bear in mind that before the news of January 22, 1997, trickled down to you, it had been filtered no fewer than four times. First, the reporter would have interpreted Greenspan’s remarks and condensed them to a few key points that made readable copy. Then, the reporter would have rendered her objective bias based on the interchange between Greenspan and senators that followed the testimony. If no senator questioned Greenspan on interest rates, the reporter might have concluded that the topic was of little news value and downplayed the story. Next, the reporter would have elicited reaction from experts. Because of deadline pressures, maybe she lacked the time to contact experts who believed rates would fall. Finally, the story would have been filtered at the copy desk, where a news editor and a night copy editor rearranged the article based on what they believed was important. One of them would have topped the story with a headline to summarize—probably in six words or less—what Greenspan said.

USE INEFFICIENCY TO YOUR ADVANTAGE

The information assembly line can severely alter our perceptions and cause us to take actions that lead to price inefficiency. But it’s to your advantage that so many investors, including many “pros,” believe in an efficient market, that a stock trading at 50 times earnings is fairly valued, and that the market can’t be beaten. As long as value investors remain an insignificant minority, there will be ample opportunity to profit from such faulty logic. Your best profits will come from bucking conventional wisdom, carefully screening your information, and waiting for investors to misprice a company. To quote Benjamin Graham, “The market often goes far wrong, and sometimes an alert and courageous investor can take advantage of its patent errors.”