It's long been a puzzle: Standard economic theory predicts that when a company releases unexpected news about earnings, its stock price should immediately reflect the new information. In reality though, it can take weeks or months for the news to sink in and for the stock price to fully incorporate revised expectations—a phenomenon known as post–earnings–announcement drift. This delayed response is just the sort of problem that interests behavioral economists, scholars who use concepts taken from psychology to explain why people sometimes make irrational financial decisions.
Why exactly would investors take so long to react to important company news? Stefano DellaVigna, Daniel E. Koshland, Sr. Distinguished Professor of Economics and Professor of Business Administration at UC Berkeley, and co–author Joshua M. Pollet suggest that some investors don't react right away to new information because of limits to their attention. In "Investor Inattention and Friday Earnings Announcements," published 2009 in The Journal of Finance, DellaVigna and Pollet cite underreaction to information as the reason for stock–price drift and point to investor distraction as the probable cause.
To test this idea, the authors examined a well–known stock market pattern—the Friday Effect. Stock turnover is generally lower and price movements less pronounced on the last trading day of week. Companies with bad news to report often take advantage of this slowdown by making their announcements on Fridays. DellaVigna and Pollet looked at 143,583 earnings announcements made from the beginning of 1995 to June 2006, including 8,166 announcements issued on Fridays. They found that the immediate response to Friday announcements was 15 percent lower than to news released on other days, while the delayed response was 70 percent higher. For Friday announcements, the delayed stock price response represented 60 percent of the total response, while for announcements made on other days, the delayed response equaled only 40 percent of the total. In addition, the flurry of trading that typically follows earnings announcements was 8 percent lower in volume after Friday releases than after announcements issued on other days.
What's going on? DellaVigna and Pollet suggest that the number of distracted investors is higher on Fridays than on other days because people tends to be diverted by thoughts about the upcoming weekend. "On Friday, investors are distracted from work-related activities," they write. "Given limited attention, distractions cause underreaction to the earnings information." However, that underreaction is temporary. "Eventually, investors become aware of the information they neglected and trade accordingly," the authors note. "The stronger delayed response … reverses the initial underreaction."
That greater level of inattention on Fridays explains why company managers who want to maximize short-term share value often release disappointing earnings projections on that day. In addition, DellaVigna and Pollet say that investors theoretically can exploit the Friday Effect to earn extra income. They estimate a trading strategy that buys stocks of companies making earnings announcements on Fridays and sells stocks of companies releasing news on other days would earn monthly returns approximately 4 percentage points higher than what would be expected based on standard stock price models.
DellaVigna and Pollet's paper provides evidence that the quality of investor decisionmaking declines in response to distractions, increasing the delayed reaction of stock prices to new information. This finding represents a significant contribution of behavioral economics to financial theory. The idea that factors such as limits to attention can affect stock prices and magnify post-earnings-announcement drift reinforces the point that financial models should take into account psychological dynamics.
