Buying the Rumour, Selling the Fact – 4 tips to help you win!

Quite often I speak to clients who have just seen on the news or read in the paper that XYZ company is looking to merge with ABC company, and is willing to pay a phenomenal price per share. The commentary will usually include an expectation for the share price to rise, and that investors in XYZ are likely to make a fantastic return.

Headline

If a headline is in the newspaper, then the stock market has usually already reacted. Whether that is in a positive or negative sense. While the newspaper in years gone by was the key information source, the Internet now provides us with instantaneous assimilation of newsworthy data.
Stock prices will rise and fall as investors perceive company announcements, industry news, or economic data to be influential on the future profitability for the business. For example, a scheduled earnings announcement from XYZ will cause investors to buy or sell shares depending on how the results are perceived. If they exceed expectations, then investors will buy the price higher. If they fail to meet expectations, then sellers will push the price lower.

Legitimate News

Every now and then, whether it is through a legitimate news source or some statement on the internet that gains momentum, a Rumour will sweep through the markets. It could be something about a takeover bid or behind the scenes negotiations.
Investors jump on these statements in an effort to ‘get on board’ a share before it starts to rally strongly. The increased buyer activity causes other investors to take note, and the momentum of buyer influence increases, driving the share price higher. When an announcement is finally made, or when the company denies the rumour, the share price will revert back to a perceived fair value according to how the rumour is valued for future performance. This can quite often result in the share price gapping in either direction. Hence, investors can make an “overnight” windfall from their investment.

How can you tell whether a rumour is legitimate?

Bottom line is, that you can’t! Unless you conduct an extensive amount of research and conclude (independently) that there is validity behind the rumour, you are basically taking a guess as to whether or not you should invest in the stock.
And with the amount of information streaming through the internet, there is an overwhelming amount of rumours and supposed ‘fact’ about future events for listed stocks. Statements such as “I know a guy who works in head office who says ….” or “my cousin is on the board and told me ….”.

The Rumour Mill

In 15 years as an advisor and trader, I cannot recall one instance when I have seen the Rumour mill produce a life changing trade. Certainly I have experienced holding stock positions where the share price gaps due to an announcement or event. However, those are common occurrences that are mostly ‘lucky’ events.

Emotional Attachment

Quite often an investor will have an emotional attachment to a company, and any headline will reinforce their pre-existing belief that the share price should be rising, or should be higher. This will lead the investor to buy into the stock, and in many cases, buying a larger amount that unbalances their portfolio.
To be quite honest, this is a very Risky method of ‘punting’ that more often than not results in losses larger than what should have occurred. It reiterates the point that Money Management and Risk Management are far more important than the investment selection process (although this is by no means unimportant).

4 Easy solutions to help define entry into a Rumour

If you are adamant that there is validity in a rumour, then the best course of action is to apply some simple Technical Analysis techniques to evaluate the balance of Buyers and sellers.

1. Evaluate the trend of the stock. If there is any momentum behind the rumour, you will see a gradual improvement in buyer activity through the trend, price activity (I use Japanese Candlesticks to read price), and with increasing volume.
2. If a share price has already gapped, you have missed the boat! Don’t go chasing that share at exceptionally high prices. This is where the early birds are already selling, and you will be the sucker who is left standing with shares without a chair to sit on (that is, without anyone to sell to).
3. As soon as the announcement is made to the market, close your position. Too often I find clients will continue holding onto shares after they have gapped up ‘hoping’ the share price will rise even further. If you have made a great return, take your profit. Don’t “Hope and Pray” you will make more because Greed will see you losing more often than not.
4. Finally, beyond all other factors, don’t bet the farm! Investors with small amounts of capital want to turn it into millions in one trade. The probability of achieving this is so low that in 15 years in the industry I have never once seen this approach being successful.