The Availability Heuristic and Investors' Reaction to Company-Specific Events

Abstract

Contemporary research documents various psychological aspects of economic decision making. The main goal of our study is to analyze the role of the availability heuristic (Tversky and Kahneman [1973, 1974]) in financial markets. The availability heuristic refers to people's tendency to determine the likelihood of an event according to the easiness of recalling similar instances and, thus, to overweight current information as opposed to processing all relevant information. We define and test two aspects of the availability heuristic, which we dub outcome and risk-availability. The former deals with the availability of positive and negative investment outcomes and the latter with the availability of financial risk. We test the availability effect on investors' reactions to analyst recommendation revisions. Employing daily market returns as a proxy for outcome availability, we find that positive stock price reactions to recommendation upgrades are stronger when accompanied by positive stock market index returns, and negative stock price reactions to recommendation downgrades are stronger when accompanied by negative stock market index returns. The magnitude of the outcome availability effect is negatively correlated with firms' market capitalization, and positively correlated with stock beta, as well as with historical return volatility. Regarding risk availability, we find that on days of substantial stock market moves, abnormal stock price reactions to upgrades are weaker, and abnormal stock price reactions to downgrades are stronger. Both availability effects remain significant even after controlling for additional company-specific and event-specific factors, including market capitalization, stock beta, historical volatility of stock returns, cumulative excess stock returns over one month preceding the recommendation revision, rating category before the revision, and number of categories changed in the revision.