Everything is Relative: Underlying Mechanisms Affecting Investor Reactions to Contrast Effects in the US Financial Market

Abstract: Contrast effects influence our perception of information because it biases us to perceive matters relative to each other and not by their absolute values. This paper explores contrast effects in a financial setting. Contrasts are measured by comparing earning news of firms with announcement dates following each other. We replicate and extend a study conducted by Samuel M.Hartzmark and Kelly Shue (2018) in which they find that contrast effects distort market reactions to firm earnings announcements in the US financial market. We study later years (1990-2020) and expand the sample size to also incorporate small firms and we find that investors' return reactions are biased by contrast effects. We extend the study to include tests of possible underlying mechanisms affecting reactions to contrast effects. First, we test if varying market conditions influence the effect. We find that for positive earnings surprises, reactions to contrast effects decrease as market strength increases and for negative earnings surprises, reactions to contrast effects increase as market strength increases. Second, we look at contrast effects in relation to behavioral psychology and find that the varying return response to previous days' earning surprises could be explained by investor loss aversion. After studying these potential mechanisms, the conclusion is that both factors influence investors' reactions to contrast effects.