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The Importance of Communication in Financial Markets

Posted by
Swiss Finance Institute
on
Friday, October 28, 2016 - 09:00

The importance of communication in financial markets

 

What impact can word choice have on listeners? The power of words to trigger changes in society or the political landscape is evident in the fact that leaders have managed to spark action and inspire multitudes of people by well-written, well-delivered speeches. The famous “I have a dream” speech by Dr Martin Luther King Jr. continues to inspire over fifty years on, for example.

 

In an interview by the Goethe Institut, Dr. Thilo von Trotha, a former political speech-writer, highlights the many ways that speeches can affect politics. For example, Dr. von Trotha described a situation where the use of one phrase by German Chancellor Angela Merkel affected health policy. The use of the phrase “capitation fee”, which has a negative connotation, seemingly had an adverse effect on the proposed health reform. The connotations of words, the use of euphemisms and the actual delivery of a speech affect its impact. This is true for communication in financial markets as well. For example, Prof. Alexander Wagner, SFI@UZH, finds in his research that the degree to which a manager talks straight or vaguely has an impact on the market’s reaction.

 

Communication and its effect on financial markets

 

The speeches of Alan Greenspan, former Chairman of the Federal Reserve Board of the USA, are thought to have impacted global markets on numerous occasions. In their paper The Greenspan Effect: A Retrospective Analysis of Alan Greenspan’s Speeches, Graddy and Beauchamp cite examples of this phenomenon. For instance, it was believed by politicians at the time that a “one-line statement averted a market panic” in 1987, and that the use of the term “irrational exuberance” in a speech by Greenspan in 1996 had dramatic “ripple effects.”

 

Communication by leaders and influencers seems to affect the economy, although these impacts may be difficult to measure. Research into behavioral finance attempts to measure this impact on finance.

 

Behavioral finance, investor sentiment and the Baker-Wurgler sentiment index

 

Behavioral finance looks at issues like investor sentiment and other psychological and social factors that affect the markets, with the underlying idea that markets do not always follow rational paths as theorized in the Efficient Market Hypothesis.

 

In their paper titled Investor Sentiment in the Stock Market, Baker and Wurgler define investor sentiment as “a belief about future cash flows and investment risks that is not justified by the facts at hand.” In another paper, Investor Sentiment and the Cross-Section of Stock Returns, Baker and Wurgler argue that the conventional financial theory (that unemotional investors make rational decisions that result in rational valuations of stocks) is incomplete in that it does not account for dramatic changes in stock prices that seem to defy logical explanation. The study of investor sentiment attempts to fill this gap.

 

Baker and Wurgler set out to empirically investigate what they see as the “intrinsically elusive concept of investor sentiment”. Their research concludes that investor sentiment does affect stock prices.

 

They posit that the question nowadays is not whether investor sentiment has an effect, but rather, how to measure its effect. Since it is difficult to accurately measure what seems to be the intangible factor of investor sentiment, proxies are often used. For example, the Baker-Wurgler sentiment index looks at six proxies which are: trading volume based on New York Stock Exchange turnover, the dividend premium, the closed-end fund discount, the number and first-day returns on IPOs (Initial Public Offerings), and the equity share in new issues.

 

However, this index is not definitive, and there appears to be no consensus on which proxies should be used to measure market sentiment.

 

It is generally accepted that a significant number of investors look at more than raw data when making a decision. Investor sentiment is driven by additional information including earnings calls and reports by executives, as well as information from analysts and the media. Therefore effective communication can sway investor sentiment.

 

The impact of a communication strategy and style on business

 

CBS Moneywatch defines investor sentiment as “the propensity of individuals to trade on ‘noise’ and emotions rather than facts.” If “noise” affects sentiment, then whatever noise is created in the marketplace (via communication by market leaders or business owners) becomes important.

 

Communication can, therefore, convey real news, but it can also impact sentiment. Both real news and pure sentiment can impact markets and prices. It is, therefore, important for businesses to have a communication strategy and style to ensure that the correct messages are being sent to investors, to avoid market speculation and market panic and to increase market stability. Effective communication can assist in ensuring that the sentiment created in the market is accurate. Prof. Philippe Bacchetta, SFI@UNIL, has been researching the effect of negative sentiment and how it can cause financial crises to spread.

 

In our upcoming series of articles on the impact of communication strategies on business and finance, we will look in more detail at:

 

  • How managerial tone affects market reactions (Prof. Wagner SFI@UZH).
  • How managers’ vagueness can affect market expectations and the impact of behavioral finance (Prof. Wagner SFI@UZH).
  • How negative sentiment can cause financial crises to spread (Prof. Bacchetta SFI@UNIL) .
  • Market irrationality in the media and its effects on stock returns (Prof. Gibson Brandon SFI@UNIGE).