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Reference point formation and investor sentiment
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School of Economics |
Master's thesis
Electronic archive copy is available via Aalto Thesis Database.
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Language
en
Pages
67
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Abstract
The purpose of this thesis is to study news-related reference point formation by market
investors. I hypothesize that investors form reference points following salient, surprising
firm-specific events, which are in this study represented by earnings announcements. To
assess the existence of the phenomenon, I run tests based on abnormal trading volume
around crossings of hypothesized reference points, which jointly test for the existence of a
reference point and the disposition effect, i.e. the tendency of investors to sell winning
stocks prematurely and to hold on to losing stocks. I also link investor sentiment to these
tests, and argue that the reference point formation effect should be found to occur less
under adverse market conditions. The tests performed in this thesis were created by
Kliger and Kudryavtsev (2008), whose study remains to date the only one to study this
phenomenon. The scope of this thesis is further expanded by testing if the magnitude of
the surprise element in the earnings announcements has an effect on reference point
formation. Moreover, it is tested if firm characteristics, namely size and beta, have an
effect on the phenomenon.
The data for this study comprises all the earnings announcement events by New York
Stock Exchange (NYSE) listed companies during the time period between January 2006
and December 2008, totaling 11,622 events after necessary eliminations. The key test
metric is trading volume, which is for each event tracked for 75 days post-event and 250
days pre-event. In addition, stock price data, analyst consensus EPS forecasts, and actual
EPS figures are used for identifying hypothesized reference points and surprise element in
company-specific news content. The data is collected from the Datastream, IBES History,
and First Call databases of Thomson Financial.
The results indicate that individuals are indeed prone to the disposition effect, and that
surprise, measured in this study with both stock market reaction and actual earnings
relative to forecasted earnings, seems to be important in driving reference point
formation. This finding is highly significant with relevant t statistic values ranging from
3.33 to 6.55. However, I find evidence against my initial hypothesis of less reference
point formation occurring under adverse market conditions. On the other hand, the data
provide support for the hypothesis that the magnitude of the surprise inherent in the
earnings announcement increases reference point formation. In addition, the phenomenon
is found to be driven by small firms.