Investors' Differential Reaction to Positive Versus Negative Earnings Surprises

Abstract

Archival studies document an asymmetrically strong market reaction to positive vis-a-vis negative earnings surprises. This finding appears inconsistent with the well-known effect of loss aversion and remains unexplained. I contend that this reaction pattern can arise when investors' earnings expectations do not coincide with analyst forecasts. Numerous studies document optimistic biases in analyst forecasts. If investors perceive optimistic biases in analyst forecasts, their earnings expectations will be lower than analyst forecasts. Because the contrast between the obtained and the expected outcome determines the degree of perceived surprise, an investor expectation which is below the analyst forecast results in a larger (smaller) perceived earnings surprise than reported when the surprise is positive (negative). Investors' lower expectations relative to analyst forecasts therefore result in a stronger reaction to positive than to negative reported earnings surprises of equivalent magnitude. In a controlled experiment, I replicate the asymmetrically strong reaction to positive reported earnings surprises, and trace this reaction pattern to investors' perceptions of these surprises. I further show that when earnings surprises are measured based on investors' perception of those surprises, the differential reaction pattern reverses: investors react asymmetrically strong to negative vis-a-vis positive perceived earnings surprises, consistent with loss aversion. My findings carry implications for investors and accounting researchers.