Country-Level Loss Aversion and the Market Response to Earnings News

SynopsisThe research problemThis study examined whether country-level loss aversion influences how investors respond to earnings news. Specifically, I examined the stock price sensitivity to negative earnings news vis-à -vis positive earnings news.MotivationInvestor expectations about the amount, timing, and uncertainty of future cash flows largely determine a firm’s stock price. An earnings announcement’s primary role is to update expectations, which in turn leads to an update in firms’ stock prices. Historically, researchers have assumed an efficient and unbiased valuation process. However, the last quarter century has seen advances in areas such as behavioral finance that raise the question of under which conditions these assumptions no longer hold. This study investigated the role of investor loss aversion in the market response to negative and positive earnings news.The test hypothesesThe first hypothesis is that country-level loss aversion is positively associated with the market response to negative earnings news. Second, country-level loss aversion is negatively associated with the market response to positive earnings news. Third, these associations are moderated by a country’s degree of short-term orientation, restraint vs. indulgence, power distance, and rule of law.Target populationThe target population includes all available publicly traded companies.Adopted methodologyI used OLS on a pooled sample of archival data.AnalysesI examined 266,630 annual earnings announcements across 45 countries from 1988 to 2021. I identified country-level loss aversion with two recently developed measures and ascertained investors’ sensitivity to earnings news using earnings response coefficients (ERCs) at both the pooled and country level. ERCs highlight how short-window stock returns covary with earnings news.FindingsThe results indicated that investors are more sensitive to bad earnings news in more loss-averse countries. In contrast, investor sensitivity to good earnings news is generally unassociated with loss aversion. Further analysis indicated that a subsequent return drift to extreme bad news is present among low-loss-aversion countries but not high-loss-aversion countries, suggesting that loss-averse investors more fully incorporate bad earnings news into stock prices. In contrast, the return drift to extreme positive news is detectable regardless of the level of loss aversion. The influence of loss aversion is more pronounced in countries with a short-term orientation and in countries characterized as more restrained.