How Well Do Investors Understand Loss Persistence?

Posted: 9 Feb 2010 Last revised: 14 Dec 2010

Date Written: January 29, 2010

Abstract

This paper examines investors' expectations of loss persistence. I develop a model to forecast loss firms' future earnings based on Joos and Plesko (2005). This model produces smaller forecast errors than random walk models or a model that assumes losses are transitory. The results suggest that investors do not fully distinguish the differences in loss persistence captured by the model, and instead appear to assume that all losses are transitory. Consequently, investors are surprised by future announcements of negative earnings for firms with predicted persistent losses, and these firms experience significantly negative abnormal returns over the following four quarters. Additional results indicate that the future negative returns of firms with predicted persistent losses are smaller in magnitude when these firms are followed by analysts. The results are robust to controls for various price anomalies and are not driven by short sales constraints.

Keywords: loss persistence, investor optimism, behavioral heuristics, stock returns

JEL Classification: M41, G12, G14

Suggested Citation

Li, Kevin K., How Well Do Investors Understand Loss Persistence? (January 29, 2010). Review of Accounting Studies, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1549832

Kevin K. Li (Contact Author)

Santa Clara University ( email )

500 El Camino Real
Santa Clara, CA 95053
United States

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