Prior research finds that individual (retail) investors often fail to use accounting information when making stock trading decisions. Instead, many individuals underperform by trading on attention-grabbing technical trends such as high past stock returns.
A number of Securities and Exchange Commission (SEC) regulations are designed to help individual investors make better trading decisions by reducing their costs of using accounting information. For example, part of the SEC’s motivation for recent regulations on hyperlinking and XBRL was to aid individuals by reducing their costs of monitoring and accessing firms’ accounting reports. In a recent study, we investigate why many individual investors disregard accounting information. This question is important for understanding what types of SEC regulations are likely to be effective in helping individuals incorporate relevant accounting information into their trading decisions.
We examine a setting where individual investors are simultaneously presented with both summarized earnings news as well as information about recent stock returns (momentum). While we find that these individuals do use stock momentum to inform trading decisions, there is no evidence that they incorporate earnings news into their trades. These findings indicate that many individual investors disregard accounting information even when it is in a simple format and immediately at hand, which raises questions about the efficacy of regulations that are designed to increase individuals’ awareness of, and access to, accounting reports. Rather, our findings indicate that many individuals disregard accounting reports either because they don’t understand how to appropriately incorporate accounting information into trading decisions, or because of behavioral biases.
SEC regulations and the costs of using accounting information
Protecting individual investors has been a longstanding priority of the SEC. The SEC has acknowledged that individual investors, relative to their professional counterparts, typically have less time and resources to devote to investing, which puts them at a competitive disadvantage. For example, individuals may find it too costly to continually monitor for information about a firm, to search and acquire information within a firm’s report, or to spend time and effort learning how accounting information is used in valuation models. We define these costs as awareness costs, acquisition costs, and integration costs, respectively, and we focus on examining whether awareness costs and acquisition costs are barriers to individuals’ use of accounting information.
Several SEC rules and regulations—including FD, XBRL, and hyperlinking—are designed to benefit individual investors by increasing investor awareness and reducing the costs of accessing and acquiring information from firms’ accounting reports. In addition, the SEC’s repeated emphasis on plain language disclosures attempts to reduce investors’ costs of accessing information in narrative reports, especially for less sophisticated investors who may not understand technical jargon. Inherently, the idea behind these regulations is that individuals will be more likely to use accounting information if the costs of monitoring and accessing accounting reports are reduced.
However, it is unclear whether awareness and acquisition costs are responsible for individuals’ neglect of accounting information. There are at least two other reasons why individuals would disregard accounting reports in trading decisions. The first is that individuals lack an understanding of how to use accounting information in valuation models, even when the information is readily available. Second, a psychology-based explanation is that behavioral biases such as overconfidence in technical trading strategies prevent individuals from using earnings information. If either of these reasons significantly affects individuals, then regulations designed to increase individual investors’ awareness of, and access to, accounting reports are unlikely to make much difference on their own.
We examine our research question using the setting of the Associated Press’ (AP’s) introduction of automated news articles. These articles are highly standardized and present both the firm’s current earnings news and recent stock returns. Several features of this setting allow us to identify and isolate likely trading by individual investors, and whether they are choosing to trade on accounting information (earnings news) or technical trends (recent stock returns).
We first investigate whether individuals neglect accounting information simply because they aren’t aware that a new accounting report has been released. If awareness costs typically prevent individuals from using accounting information, then individuals who trade in response to the automated articles (which clearly state that an earnings announcement has happened) would incorporate earnings news into their trading decisions. We find no evidence of a relation between incremental trading and the firm’s earnings news, which we interpret as these individuals disregarding accounting information even when awareness costs no longer exist.
We next examine whether acquisition costs are the primary barrier to individuals’ use of accounting information in trading decisions. Some of the automated articles provide the analyst consensus forecast, which allows investors to easily calculate the earnings surprise with minimal cost. We continue to find no evidence of a relation between incremental trading and the firm’s earnings news even when the analyst consensus forecast is clearly presented. This finding suggests that eliminating acquisition costs is also insufficient to motivate these individuals’ use of accounting information.
In contrast, we find a strong relation between incremental trading and the firm’s recent stock returns presented in the articles. Thus, individuals who trade in response to AP’s automated articles choose to trade on technical trends and disregard earnings news that has been shown to improve trading decisions.
Our study takes a step towards understanding the specific frictions that are responsible for individual investors’ under-use of earnings information. Understanding the extent and influence of information frictions on individual investors’ trading decisions is of interest not only to researchers and investors, but also to regulators as they work to develop effective investor protections. An important caveat in our study is that the individual investors who trade in response to AP’s articles are unlikely to represent all individual investors, but instead likely characterize “attention investors” who trade on attention-grabbing trends and events. Still, AP’s automated articles drive a roughly 11 percent increase in trading volume, which indicates that the population of investors examined in this paper is sizable. We find that these individual investors do not use accounting information even when it is readily at hand, which suggests that regulations aimed at reducing information awareness and acquisition costs are unlikely to change these investors’ trading behavior. Overall, our findings highlight the need to better understand the potential benefits of regulations that aim to “level the playing field” for individual investors.
This post comes to us from Professor Elizabeth Blankespoor at Stanford University, Professor Ed deHaan at the University of Washington, PhD student John Wertz at the University of Washington, and PhD student Christina Zhu at Stanford University. It is based on their recent article, “Why Do Individual Investors Disregard Accounting Information? The Roles of Information Awareness and Acquisition Costs,” available here.