When Paying Attention Is Not Enough: Investor Misreactions to Accounting Information

Abstract

Do investors process accounting information more efficiently when they pay more attention to it? Because accounting information is highly technical, attention alone may not guarantee timely and correct investor reactions. Investors who lack access to proprietary sources of information potentially most benefit from the accounting information in publicly available financial reports, but they are also least likely to have sufficient resources to analyze it, even when they seek it out. I explore this idea using the theory of Hirshleifer et al. (2011), which contends that investor reactions to accounting information depend on the costs required to process it. I propose that such costs depend on the type of investor and the type of accounting information. Based on this theory and proposition, I predict that individual investors bear marginal information processing costs that are significantly lower for earnings than for its components, leading them to fixate on the former and ignore the latter. To test my predictions, I create a novel firm-specific measure of individual investor attention to accounting information. This measure is positively associated with responses to earnings news, which is not the case for existing measures of general attention to the firm. Using archival analysis techniques, I confirm that when individual investor attention to accounting information is high, the post-earnings announcement drift and the underreaction to earnings are weaker. Simultaneously, however, the overreaction to accruals is stronger, which indicates that the investors fixate on the summary earnings number without analyzing its components. As predicted, the last result is unique to the active attention of individual investors and does not hold for sophisticated investors or for passive attention driven by the media. Collectively, my findings suggest that individual investors’ limitations in processing technical aspects of accounting information are not offset by paying attention.

Keywords: investor attention, retail investors, capital market efficiency, information processing costs, Internet search traffic

JEL Classification: D83, G14, M41