Disclosure Standards and the Sensitivity of Returns to Mood

Posted by Henry Friedman, University of California, Los Angeles, on Monday, December 7, 2015

In our paper, Disclosure Standards and the Sensitivity of Returns to Mood, forthcoming in the Review of Financial Studies, we provide evidence that high-quality disclosure standards are negatively associated with return-mood sensitivity (RMS). Using daily data, we estimate RMS for each country-year as the association between market returns and deseasonalized cloudiness in the city that hosts a country’s stock exchange. We interpret RMS as reflecting noise in returns because short-term moods are unlikely to convey fundamental information.

Although urban cloudiness is a salient noninformative signal that investors should disregard, cloudiness has a negative influence on mood. Susceptible investors may view their mood as an informative signal relevant to trading decisions. With higher-quality disclosures, susceptible traders will have more precise information about firm fundamentals, lessening the influence of mood on subjective valuations and trading decisions (Hirshleifer and Shumway 2003; Clore, Schwarz, and Conway 1994; Forgas 1995). High-quality disclosures also provide information that facilitates arbitrage, further reducing noise driven by shocks to short-term mood.

We find that the average degree of RMS varies greatly across countries, suggesting that there are country-level factors, such as disclosure standards, that mitigate or exacerbate the effect of mood on market returns. We create country-year measures of disclosure standard quality using the World Economic Forum’s Global Competitiveness Report and the disclosure index from the Center for International Financial Analysis and Research (CIFAR). We find consistent evidence that higher-quality disclosure standards are significantly associated with less return-mood sensitivity. These findings are consistent with higher-quality disclosures reducing the noise in returns induced by susceptible investor trading.

We provide additional insight into the relation between disclosure standards and RMS by examining cross-sectional variation in this relation. First, if disclosure standards affect the likelihood that susceptible investors trade based on information, rather than on cloudiness-induced mood, then countries with a higher level of susceptible investor participation should experience larger reductions in return noise from higher-quality disclosure standards. We find weak evidence that disclosure standards have a greater effect on return noise when susceptible investor participation is greater. Second, higher-quality disclosure standards can facilitate sophisticated investors’ information gathering and processing, increasing the likelihood that they can arbitrage away mood-based noise in stock prices. Consistent with the arbitrage-facilitation mechanism, we find that high-quality disclosure standards have the biggest effect in reducing RMS in countries with relatively high mutual fund holdings and a low fraction of shares held by insiders.

To ensure that our results are not an artifact of the international setting, we also test our hypotheses in a sample of U.S. firms. We estimate RMS and disclosure quality at the firm-year level and find that high-quality disclosure is negatively associated with RMS in firms with high individual (i.e., susceptible) investor participation. The negative association is most pronounced when sophisticated investor participation is also high. We also find that firms with higher recent idiosyncratic volatility, that is, those firms likely to be more susceptible to sentiment (Baker and Wurgler 2006), tend to have higher RMS and larger negative associations between disclosure quality and RMS. Thus, the U.S. evidence is consistent with our international results.

Our evidence contributes to the debate over the efficacy of regulation in improving price efficiency. We focus on return noise resulting from mood-susceptible traders, who are exactly the types of traders that securities regulators like the SEC implicitly target when enacting regulation. For example, disclosure standards are frequently motivated as a policy tool to protect relatively uninformed retail investors. Langevoort (2009, 1043) notes “The SEC’s habitual use of the disclosure remedy for purposes of retail investor protection, for instance, rests on the unexamined (and often dubious) premise that investors who fall sufficiently short of the rational actor model to require paternalistic intervention will necessarily process the information rationally once it is delivered to them.” To the extent that higher-quality disclosures help susceptible investors calibrate their sensitivities to various signals, and tilt away such traders from trades based on noninformative signals, our study suggests that disclosure regulation can effectively reduce noise in prices.

The full paper is available for download here.