Stock Market Commentators

How seriously should we take commentators who predict future stock price movements? To figure this out, we first have to examine why anyone would widely disseminate his stock picks.

Pretend a pirate claims to know the location of a buried treasure. You figure there’s a 1 percent chance that he is both sane and honest. The pirate then gives you a usable map that seems to show the exact location of the treasure. Do you still believe the pirate? Since it’s unlikely that a sane pirate will reveal the location of treasure, the fact that the pirate freely tells you where his treasure is buried reduces the chance that he actually has any useful information.

Now imagine that instead of a pirate revealing the whereabouts of a treasure, a financial analyst reveals the name of a stock she claims will rapidly increase in value. The analyst’s willingness to part freely with this information should itself eviscerate the credibility of that information. Knowledge about what stock will increase is valuable. If the analyst were someone whom many people believed and trusted. then the analyst would never just give away this information; she would sell it. Might not the analyst, however, both sell this information and freely reveal it? No. Those who paid would be upset that they had to pay for something others got for free. Consequently, the fact that the analyst willingly disseminates this knowledge shows that either the analyst does not believe her own predictions or lacks the credibility to actually get paid for this information.

What if the analyst works for a business publication, writing articles concerning which stocks will increase? If the owners of the magazine really believed in the analysis, they would not disclose the predictions but would trade on them themselves. No sane magazine owners would publish a map to a buried treasure if they believed the map to be accurate and the treasure to be precious. Similarly, sane magazine owners would sell the predictions for the price of their magazine only if they didn’t believe that the predictions were valuable.

It’s possible that the analyst is reliable, but no one believes her, and so the analyst can’t sell this valuable information. If you do choose to follow this analyst’s advice, however, you should at least acknowledge that the market doesn’t value her opinion. People in the financial industry don’t think this information has much value, or the analyst wouldn’t freely part with her predictions.

Not all financial advice should be suspect. You shouldn’t trust a pirate who gives you his map, because the pirate himself would be hurt by your taking his treasure. There are some types of financial “treasure,” however, that everyone can enjoy. Consider two pieces of information:

1. Acme stock is undervalued.

2. Investors should diversify their portfolios.

Since only a few people can benefit from purchasing an “undervalued” stock, telling many people about (1) decreases the value of this information. In contrast, the idea that investors should diversify doesn’t decrease the value of anything when many people act on it. You should consequently trust financial advice when the advisor wouldn’t personally benefit from hoarding this information.