Directional Preferences, Information Processing, and Investors' Forecasts of Earnings

Abstract

This paper reports the results of an experiment showing that investors' forecasts of earnings are affected by the investment positions they hold and by whether they are facing the prospect of a gain or loss on those investments. The results are consistent with theories of motivated reasoning that predict when and in what manner directional preferences affect how information is processed. Specifically, investors unthinkingly accept information that implies a gain for their investment, but disagree with information that implies a loss. In addition to the asymmetry in when investors are skeptical of information, investors are also biased in how they disagree: long investors expect higher future performance and short investors expect lower future performance. These results have important implications for understanding not only investor behavior, but also the behavior of market participants who face conflicts of interest, such as analysts, managers, and auditors, by providing direct evidence that such behavior can arise for purely psychological reasons. By providing evidence on how information processing is affected, the findings suggest testable predictions for accounting "fixation" effects and for the association of price and forecast biases with the favorability of public information, market-wide short interest, forecast dispersion, and trading volume.

Keywords: Motivated reasoning, independence, optimism, forecast bias and dispersion