On 31 January 2006, Google announced its financial results for the final quarter of 2005. Revenue: up 97%. Net profit: up 82%. A record-breaking quarter. How did the stock market react to these phenomenal figures? In a matter of seconds, shares tumbled 16%.Trading had to be interrupted. When it resumed, the stock plunged another 15%. Absolute panic. One particularly desperate trader inquired on his blog: ‘What’s the best skyscraper to throw myself off?’

What had gone wrong? Wall Street analysts had anticipated even better results, and when those failed to materialise, $20 billion was slashed from the value of the media giant.

Every investor knows it’s impossible to forecast financial results accurately. The logical response to a poor prediction would be: ‘A bad guess, my mistake.’ But investors don’t react that way. In January 2006, when Juniper Networks announced eagerly anticipated earnings per share that were a tenth of a cent lower than analysts’ forecasts, the share price fell 21% and the company’s  value plunged $2.5 billion. When expectations are fuelled in the run-up to an announcement, any disparity gives rise to draconian punishment, regardless of how paltry the gap is.

Many companies bend over backwards to meet analysts’ predictions. To escape this terror, some began publishing their own estimates, so-called ‘earnings guidance’. Not a smart move. Now, the market heeds only these internal forecasts – and studies them much more closely to boot. CFOs are forced to achieve these targets to the cent, and so must draw on all the accounting artifices available.

Fortunately, expectations can also lead to commendable incentives. In 1965, the American Psychologist Robert Rosenthal conducted a noteworthy experiment in various schools. Teachers were told of a (fake) new test that could identify students who were on the verge of an intellectual spurt – so-called ‘bloomers’. Twenty percent of students were randomly selected and classified as such. Teachers remained under the impression that these were indeed high- potential students. After a year, Rosenthal discovered that these students had developed much higher IQs than other children in a control group. This effect became known as the Rosenthal effect ( or Pygmalion effect).

Unlike the CEOs and CFOs who consciously tailor their performance to meet expectations, the teachers’ actions were subconscious. Unknowingly, they probably devoted more time to the bloomers, and consequently, the group learned more. The prospect of brilliant students influenced the teachers so much that they ascribed not just better grades but also improved personality traits to the ‘gifted’ students – a tribute to the halo effect.

 

Source: The Art of Thinking Clearly by Rolf Dobelli

 

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Romit Barat
Romit Barat
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Romit is highly experienced in understanding Market Dynamics. He's a voracious reader and his flair for writing is deep rooted in his noteworthy insight on market behaviors that otherwise go unnoticed.

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