Overly Optimistic? Investor Sophistication and the Role of Affective Reactions to Financial Information in Investors' Stock Price Judgments

Abstract

This study investigates the difference in unsophisticated and sophisticated investors' affective reactions to a firm's positive earnings announcement. The study also investigates the variation in the stock price judgments of these two groups as a result of a differential reliance on the affective reaction. It contributes to the literature by providing a further understanding of the differential interpretation and reaction to financial data by investors with varying levels of knowledge and experience. In the experiment, participants were asked to review background financial information about a company, evaluate the company's earnings announcement and make stock price judgments. Results indicate that unsophisticated investors interpret a positive earnings announcement as more favorable than do sophisticated investors. The affective reaction to the earnings announcement was more influential on the stock price judgments of unsophisticated investors when compared to the stock price judgments made by sophisticated investors. This differential effect leads unsophisticated investors to make stock price judgments that exceed stock price judgments made by sophisticated investors. From a back to basics standpoint, these results suggest that investment-related knowledge and experience play a significant role in how individual investors react to and rely on basic financial information, which may be of interest to standard setters and regulators.