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Explaining Investors’ Fixation on Increasing Revenue. An Experimental Investigation of the Differential Reaction to Revenues Versus Expenses.

Fri, October 4, 1:45 to 3:15pm, TBA

Abstract

Prior research by Ertimur et al. (2003) has archivally demonstrated that investors have differential reactions to revenue increases versus expense decreases in firms with positive earnings surprises and offer differential levels of persistence as an explanation for this curious unexpected finding. We use an experimental method to explain this differential reaction including how it might lead to suboptimal investment decisions. Specifically, we find that, even when earnings surprises caused by either revenue increases or expense decreases are equally persistent, that investors still employ a heuristic-like process in their judgments. This is consistent with explanations from research in psychology such as the halo bias and mental accounting theory. We demonstrate that even when investors make similar predictions for future earnings, their judgments about current earnings are more positive when even small amounts of revenue increases are responsible for a positive earnings surprise. Suggesting that the differential response seen in prior work is at least partially due to bias in their decision-making processes.

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