What Limited Attention Does to Efficient Market Theory

Stocks don’t react to news immediately because, well, we’re human

Today’s easy access to financial disclosures would seem to feed into the efficient market theory. Whether you’re an individual investor relying on Yahoo Finance or a professional glued to your Bloomberg terminal, seamless electronic dissemination of earnings releases and quarterly financial statements should translate to stock prices quickly and fully reflecting newly available data.

And yet, it often doesn’t. A growing body of academic research — much of it published in the past 20 years or so — documents how efficient market theory runs into the speed bump of limited investor attention. Competing claims on a human’s ability focus on, process, and understand new information can lead to less efficient price reaction, measured in days, not minutes or hours.

Moreover, corporations have become deft at exploiting limited attention, choosing periods of high inattention to dump bad news (see: Friday, after the market close) and deploying attention-getting methods when there is good news they hope to leverage into a stock price bump.

The Many Ways in Which Information Is Ignored

In the forthcoming Handbook of Financial Decision Making, University of Illinois’ Alexander Nekrasov, UCLA Anderson’s Siew Hong Teoh, and Chinese University of Hong Kong-Shenzhen’s Shijia Wu parse more than 80 research papers explaining why and how stock prices are captive to various manifestations of investor inattention.

A slower price reaction can be the result of straightforward inattention: If a stock is not closely tracked by all investors, it can take more time for the broad market to catch up to the news. Or it can be triggered by information overload during a too-busy earnings announcement season when analysts and institutional investors have to choose which company to cover first, which means becoming inattentive to others. Or it can come down to market news being crowded out by bigger goings on in the world.

UCLA Anderson’s Teoh’s work is a through-line in research over the past 20 years. This review draws on models presented in 2003 research Teoh collaborated on with the University of Southern California’s David Hirshleifer, 2009 research by Hirshleifer, Teoh and DePaul University’s Sonya S. Lim, and 2020 research Teoh collaborated on with Nekrasov and San Francisco State University’s Yifan Li.

The most prevalent manifestation of the market impact of limited attention, the review authors report, is the tendency for stock prices to “drift” after an earnings announcement, reflecting the days it can take for investors who aren’t closely glued to the news to catch up to the subset of investors and analysts who follow it like a hawk.

Research has shown that when there are lots of “inattentive” investors the immediate stock price reaction to earnings news will be muted or slower and sometimes both. The initial stock movement is also lessened when a company opts to release earnings only and waits to release the full financial statement. The amount of drift in a price after an earnings announcement will be greater when there are more inattentive investors in the mix, and again, when the full financial statement is not released alongside earnings.

The authors note that retail investors are most susceptible to slowly catching up to the news. But institutional investors are not immune either, though their inattention is born from information overload.

Distraction as a Strategy to Share Bad Earnings News

Research published in 2020 documented that analysts are less likely to issue timely earnings forecasts and weigh in on earnings calls, and are slower to issue a stock recommendation, for a given company when they are juggling another company announcing on the same day. This seems to be tactical triage, as analysts who devote immediate coverage to stocks highly valued by their institutional clients are “more likely to be named all-star analysts by Institutional Investor magazine in the following year, and they are less likely to be demoted to a smaller brokerage.”

How firms choose to roll out information also plays into the limited attention of investors and analysts. Research published in 2009 provided evidence that the “high distraction” day of Friday is a popular choice for releasing bad earnings.

Firms looking to slow the absorption of bad news are wise to place it in the footnote of a statement, which gets less investor attention than the main text of financial statements. Conversely, 2014 research found that “disseminating news on Twitter increases the visibility of earnings news by reaching a broad set of investors.”

A new area of limited attention research has begun to show how visual prompts can impact the pace of news digestion. A 2021 paper found that earnings announcements made on Twitter that included a visual (graphic, GIF etc.) are retweeted more, which suggests greater attention. That fact isn’t lost on corporate management, which the research shows is inclined to use visuals out of self-interest to induce a “stronger immediate reaction to earnings news,” (say, management wants to sell shares soon) that will nonetheless be reversed, suggesting that visuals prompt investors to overreact to earnings news.

Financial technology may have come up with a workaround to human shortcoming. The authors cite 2022 research that found robo-analysts using state-of-the art tools such as natural language processing and machine learning were able to absorb and update news faster than their human counterparts.

“The evidence overall suggests that robo-analysts suffer less from limited attention compared to traditional financial analysts and can be used by the sell-side research industry to produce high quality outputs.”