A Tough Act to Follow: Contrast Effects in Financial Markets

• Date: 01 August 2018
• Author: KELLY SHUE,SAMUEL M. HARTZMARK
• Published date: 01 August 2018
• DOI: http://doi.org/10.1111/jofi.12685

THE JOURNAL OF FINANCE •VOL. LXXIII, NO. 4 •AUGUST 2018

A Tough Act to Follow: Contrast Effects

in Financial Markets

SAMUEL M. HARTZMARK and KELLY SHUE∗

ABSTRACT

A contrast effect occurs when the value of a previously observed signal inversely

biases perception of the next signal. We present the first evidence that contrast effects

can distort prices in sophisticated and liquid markets. Investors mistakenly perceive

earnings news today as more impressive if yesterday’s earnings surprise was bad

and less impressive if yesterday’s surprise was good. A unique advantage of our

financial setting is that we can identify contrast effects as an error in perceptions

rather than expectations. Finally,we show that our results cannot be explained by an

alternative explanation involving information transmission from previous earnings

announcements.

Socrates: Could you tell me what the beautiful is?

Hippias: For be assured Socrates, if I must speak the truth, a beautiful

maiden is beautiful.

Socrates: The wisest of men, if compared with a god, will appear a monkey,

both in wisdom and in beauty and in everything else. Shall we agree,

Hippias, that the most beautiful maiden is ugly if compared with the

gods?

—Plato

PEOPLE OFTEN INTERPRET INFORMATION BY contrasting it with what was re-

cently observed. For example, Pepitone and DiNubile (1976) show that people

∗Samuel M. Hartzmark is with University of Chicago Booth School of Business, and Kelly Shue

is with Yale School of Management and the NBER. We are grateful to Ross Garon at Cubist

Systematic Solutions for helpful suggestions. We thank Yiran Fan, Menaka Hampole, Michael

Watson, and Linda Ye for excellent research assistance. We thank John Beshears, Justin Birru,

James Choi, Diego Garcia, Nicola Gennaioli, Wesley Gray, Terrence Hendershott, Owen Lamont,

Bill Mayew, Quoc Nguyen, Josh Schwartzstein, Andrei Shleifer, Doug Skinner, Eric So, David

Solomon, and Boris Vallee as well as seminar participants at AFA Annual Meeting, AQR Insight

Award Meeting, Arrow Street Capital, BEAM, City University of Hong Kong, Chicago Booth,

Colorado Finance Summit, Cubist Systematic Solutions, FIRN, Frontiers in Finance Conference,

FSU Suntrust Finance Conference, Gerzensee ESSFM, Harvard Economics, Helsinki Finance

Summit, IDC, London Business School, Maastricht University,MIT Sloan JFFC, NBER Behavioral

Finance, Tilburg University, UBC Winter Finance Conference, and Wharton Jacobs Levy Forum

for comments. We thank Sam Hanson and Adi Sunderam for sharing data. The authors have

nothing to disclose with respect to the Journal of Finance’s Conflict of Interest Disclosure Policy.

DOI: 10.1111/jofi.12685

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1568 The Journal of Finance R

judge crimes to be less severe following exposure to narratives of very egre-

gious crimes, and Kenrick and Gutierres (1980) show that male students rate

female students to be less attractive after viewing videos of beautiful actresses.

References to such “contrast effects” are also pervasive in our popular culture.

People complain about having “a tough act to follow” when they are scheduled

to perform following a great performance. Writers use literary foils to exagger-

ate a character’s traits through juxtaposition with a contrasting character, and

fashion designers use shoulder pads and peplum hips to create the illusion of

a comparatively smaller waist. In all of these cases, contrast effects bias our

perception of information. We perceive signals as higher or lower than their

true values depending on what was recently observed.

Contrast effects have the potential to bias a wide variety of real-world deci-

sions. They may distort judicial perceptions of the severity of crimes, leading to

unfair sentencing. At the firm level, comparisons with the previously reviewed

candidate can lead to mistakes in hiring and promotion decisions. An uncon-

strained firm may pass on a project with a positive net present value (NPV)

because it does not look as good as other options or invest in a negative NPV

project because it looks better than worse alternatives. Finally, at the house-

hold level, contrast effects could cloud key decisions such as mate choice and

housing selection.

In these examples, contrast effects can potentially lead to costly mistakes, but

it may be difficult for researchers to cleanly measure the bias. Measurement is

complicated by the possibility that decision-makers face unobserved quotas or

resource constraints that make comparisons across multiple cases optimal. In

addition, researchers often lack precise data on how decision-makers perceive

information. Possibly because of these challenges, most existing research on

contrast effects focuses on controlled laboratory experiments. Evidence from

the field is more limited. Outside of the lab, Bhargava and Fisman (2014)

find evidence of contrast effects in mate choice using a speed dating field ex-

periment, and Simonsohn and Loewenstein (2006) and Simonsohn (2006) find

evidence of contrast effects in consumer housing and commuting choices.

Our paper tests whether contrast effects exist in another important real-

world setting: financial markets. The financial setting is particularly interest-

ing because we can test whether contrast effects distort equilibrium prices and

capital allocation in sophisticated markets. Full-time professionals who make

repeated investment decisions may be less prone to such a bias than individu-

als who make infrequent dating or real estate decisions. While the limited field

evidence shows that contrast effects exist in household decision-making, they

may not exist in financial markets where prices are determined through the in-

teractions of many investors. Thus, cognitive biases among a subset of investors

may not affect market prices given the disciplining presence of arbitrage. And

yet, if contrast effects influence prices in financial markets, they would rep-

resent an important form of mispricing: prices react not only to the absolute

content of news, but also to a bias induced by the relative content of news.

In this paper, we test whether contrast effects distort market reactions to

firm earnings announcements. Quarterly earnings announcements represent

A Tough Act to Follow 1569

the main recurring source of news released by publicly traded U.S. firms. Prior

to an announcement, financial analysts and investors form expectations of what

they believe earnings will be. Earnings surprises, that is, the extent to which

actual earnings exceed or fall short of those expectations, are associated with

stock price movements because they represent new information that shifts ex-

pectations of firm prospects. Earnings announcements are typically scheduled

weeks beforehand, so whether a given firm announces following a positive or

negative surprise by another firm is likely to be uncorrelated with the firm’s

fundamentals.

The theory of contrast effects predicts a negative relation between yesterday’s

surprise and the return reaction to today’s earnings surprise, holding today’s

earnings surprise constant. The intuition is that today’s news will seem slightly

less impressive than it otherwise would if yesterday’s earnings surprises were

positive and slightly more impressive if yesterday’s earnings surprises were

disappointing. While an earnings surprise is a concrete number (e.g., earnings

per share was $0.14, beating analyst forecasts of $0.10, translating to a positive

surprise of $0.04), there is significant subjectivity in translating a surprise into

a return response. Thus, while a positive surprise is good news, how much the

price goes up depends on one’s interpretation of what the surprise implies for

the future of the firm. We test whether the perception of “how good” is good

news (or “how bad” is bad news) is biased by contrast effects.

The downward-sloping pattern in Figure 1illustrates our main finding.

The figure shows a local linear plot of returns surrounding a firm’s earnings

announcement relative to the value-weighted average earnings surprise an-

nounced by large firms in the previous trading day, hereafter referred to as

Surpriset−1. The figure demonstrates a strong negative relation: controlling for

today’s earnings news, the return reaction to today’s earnings announcement is

inversely related to Surpriset−1. The effect is sizable—a change in yesterday’s

earnings surprise from the worst to the best decile corresponds to a 53 bp lower

return response to today’s earnings announcement.

We find evidence of a simple directional effect whereby a high surprise yes-

terday makes any surprise today (even more positive surprises) look slightly

worse than it would appear if yesterday’s surprise had been lower. In other

words, the magnitude of the return distortion depends strongly on yesterday’s

surprise and not significantly on the interaction between today’s and yester-

day’s surprise. Visually, this manifests as a vertical shift downward in the

return response curve to the firm’s own earnings surprise if yesterday’s news

was good rather than bad (see Figure 3).

While our findings are consistent with the theory of contrast effects, one

may be concerned that we are capturing a reaction to information transmit-

ted from earlier earnings announcements. Rational reaction to information

released at time t−1 implies that the information is quickly incorporated into

prices and therefore will have no predictive power for future returns. We reject

such explanations by showing that Surpriset−1negatively predicts the future

returns of firms scheduled to announce on day t,without conditioning on day

t earnings news. This allows us to create a simple trading strategy where we