Strategic Disclosure and Investor Loss Aversion

Abstract:

We examine the impact of loss aversion on voluntary disclosure behavior. Incorporating investors with prospect theory preferences into the classic voluntary disclosure setting of Dye (1985), we generate a novel, three-threshold equilibrium where managers voluntarily disclose ‘mildly bad’ but withhold ‘mildly good’ news. This asymmetric disclosure behavior is driven by managers strategically seeking to avoid the costs imposed by investor loss aversion associated with missing earnings expectations. This behavior is consistent with existing empirical evidence documenting that managers strategically guide down market expectations to avoid negative earnings surprises. The model predicts that the effect will be strongest in those settings where the degree of loss aversion among investors is most pronounced and when the signal is precise. We also find that outside these mild news regions, traditional disclosure predictions still hold. Namely, managers disclose ‘very good’ and withhold ‘very bad’ news because the influence of loss aversion diminishes quickly the farther the news is from the meet-or-beat threshold.