Limited Investor Attention and Earnings-Related Under- and Over-Reactions

Abstract

We provide a model in which a single psychological constraint, limited investor attention, explains several earnings- and investment-related anomalies. Investor neglect of current-period earnings in forming their valuations induces drift. Neglect of earnings components causes accruals and cash flows to predict abnormal stock returns. Neglect of the incremental forecasting power of other public signals for future earnings causes public information signals such as investment and net operating assets to predict abnormal returns. We derive new untested empirical implications regarding the relative strength of accruals and cash flow anomalies, and the relation between the ability of a public signal to predict returns and its incremental ability to forecast future earnings after controlling for current period earnings.