Investor Sentiment and Use of Accounting Information

This paper relies on the characteristics of different earnings components to show that sentiment affects both investors’ judgments of expected cash flows and their risk preferences. As suggested in psychology theories, those two effects of sentiment work against each other in the valuation model-optimistic (pessimistic) cash flow judgments come with high (low) discount rates during high (low) sentiment periods. Hence, the combined effects of sentiment on investors’ reactions to different earnings components, then, depend on which effect dominates the other. Prior studies show that “information uncertainty” moderates the effect on judgments. For those earnings components generating future benefits with low uncertainties, I find that the effect of sentiment on risk preferences dominates its effect on judgments, because low uncertainty leaves no room for judgments. On the contrary, for earnings components generating future benefits with high uncertainty, I find that effect of sentiment on judgments dominates its effect on risk preferences. It is consistent with findings in prior literature that cash flow shocks usually overshadow discount rate shocks.