Driven to Distraction: Extraneous Events and Underreaction to Earnings News

Abstract (Via Yale)

Psychological evidence indicates that it is hard to process multiple stimuli and perform multiple tasks at the same time. This paper tests the investor distraction hypothesis, which holds that the arrival of extraneous news causes trading and market prices to react sluggishly to relevant news about a firm. Our test focuses upon the competition for investor attention between a firm’s earnings announcements and the earnings announcements of other firms. We find that the immediate stock price and volume reaction to a firm’s earnings surprise is weaker, and post-earnings announcement drift is stronger, when a greater number of earnings announcements by other firms are made on the same day. A trading strategy that exploits post-earnings announcement drift is most profitable for earnings announcements made on days with a lot of competing news, but it is not profitable for announcements made on days with little competing news.

Introduction (Via Yale)

Since minds are finite, attention must be allocated selectively. When individuals try to process multiple information sources or perform multiple tasks simultaneously, per- formance suffers.1 Indeed, conscious thought requires a focus on particular ideas or information to the exclusion of others.

These elemental facts suggest that limited attention is likely to affect the perceptions and behavior of investors. Specifically, an investor’s effort to understand the implications for a firm of a news announcement by and about one firm may interfere with the processing of information about another firm at the same time. Although there is recent
empirical research on the effects of limited investor attention on securities prices, this basic prediction has not to our knowledge been tested.

Findings (Via Yale)

Our evidence indicates that the presence of a large number of competing earnings announcements by other firms is associated with a weaker announcement-date price reaction to a firm’s own earnings surprise, a lower volume reaction, and stronger subsequent post-earnings announcement drift. The distraction effect is more pronounced in market reactions to positive news than negative news, consistent with distraction weakening the ‘buy on news’ attention effect of Barber and Odean (2005). A portfolio trading strategy that exploits post-earnings announcement drift achieves superior performance when implemented on earnings announcements on days with a large number of competing announcements than those on days with little competing news. Competing announcements made by firms in other industries have a stronger distraction effect, whereas those by same-industry firms do not have a significant effect. Our findings generally support the investor distraction hypothesis, and suggest that investors’ limited attention may drive market underreaction to public news such as post-earnings announcement drift.

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09. February 2010 by Miguel Barbosa
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