Good news, false expectations? How people assess potential returns in the stock market

A recent study from the Universities of Bonn and Cologne reveals that both retail investors and financial professionals often misjudge the impact of company news on future stock returns, contradicting standard financial economics models. The research, titled "Mental Models of the Stock Market," was published in the Quarterly Journal of Economics.

When a company announces positive news, such as a 20% reduction in production costs, many investors may purchase shares anticipating higher future earnings and stock prices. However, stock prices typically adjust to new information immediately, rendering such expectations ineffective. The study surveyed over 7,000 participants from the U.S. and Germany, including retail investors, financial advisers, fund managers, and financial market researchers.

The findings show that roughly 60% of the general public in Germany, 74% of retail investors, and more than half of fund managers and financial advisers still expected higher returns weeks after receiving positive news, despite the information being four weeks old. Researchers attribute these discrepancies to varying mental models used to evaluate company news.

Financial market experts assume markets are efficient and consider both future profits and current stock prices, whereas retail investors focus primarily on future profits, often ignoring the effect of rising share prices on returns.