The Role of Anchoring Bias in the Equity Market

Abstract: Anchoring is the fact that, in forming numerical estimates of uncertain quantities, adjustments in assessments away from arbitrary initial values are often insufficient. We find that this cognitive bias has significant economic consequences for the efficiency of financial markets. First, analysts make optimistic (pessimistic) forecasts when the firm forecasted earnings per share (FFEPS) is lower (higher) than the industry median FEPS. Second, firms with F-FEPS greater (lower) than the industry median experience abnormally high (low) future stock returns, particularly around the subsequent earnings announcements. Third, firms with high F-FEPS relative to the industry median are more likely to engage in stock splits. Split firms with lower (higher) F-FEPS relative to the industry median experience more (less) positive forecast revisions, higher (lower) forecast errors, and more (less) negative earnings surprises after a stock split compared to non-split firms. 1. Introduction Analysts are key financial market participants. Researchers often use analysts earnings forecasts as proxies for market expectations and differences in opinion. In addition, analysts earnings forecasts are one of the rare settings for which researchers have a large natural data set of individual analysts actual decisions, and for which the biases in decision making can be observed and verified ex post. Not surprisingly, the activities of analysts have been a fertile ground for behavioral research. Prior literature has shown that analysts often suffer from different biases. For example, the prior literature has suggested that analysts (1) make upwardly biased forecasts (e.g., DeBondt and Thaler (1990)), (2) overreact to positive information but under-react to negative information (e.g., Easterwood and Nutt (1999)), and (3) are overconfident in their own skills (Hilary and Menzly (2006)). However, the implications of these potential cognitive biases for investors and, even more so, for managers are less understood. We also consider the behavior of financial market participants but from a very different perspective compared to the prior literature. We focus on the anchoring bias, a topic that has not been extensively investigated by the prior literature in both accounting and finance. Anchoring is the fact that, in forming numerical estimates of uncertain quantities, adjustments in assessments away from arbitrary initial values are often insufficient. One of the first studies in this cognitive bias is the seminal experiment by Kahneman and Tversky (1974). These authors report that the estimates of an uncertain proportion (the percentage of African nations in the United Nations) were affected by a number between 0 and 100 that was determined by spinning a wheel of fortune in the subjects presence. Subsequent research (reviewed in Section 2) has confirmed the robustness of this cognitive bias. 2 We hypothesize that market participants, such as sell-side analysts and investors, are also affected by the anchoring bias, when they estimate the future profitability of a firm. This estimation is a complex task that involves a high degree of uncertainty. This suggests that market participants naturally anchor on salient information such as the industry median forecasted earnings per share (I-FEPS). If this conjecture is correct, this should have important implications for the behavior of analysts and investors.

First, if analysts anchor on the median industry FEPS, their forecasts should be too close to this number. As a consequence, analysts are likely to underestimate the future earnings growth of firms with high FEPS (F-FEPS) compared to the industry median FEPS. In other words, analysts give more pessimistic earnings forecasts for firms with high FEPS than for similar firms in the same industry with low FEPS. As a result, earnings forecast errors should be lower for high F-FEPS firms than for low F-FEPS firms in the same industry. Second, if investors behave like analysts and also anchor on the industry median FEPS, their expectations of future profitability should be biased. Firms with an already high F-FEPS compared to their industry should suffer from low expectations regarding their future profits. Conversely, firms with a low current F-FEPS relative to their industry should enjoy high expectations regarding their future profits. If this is the case, stocks with high F-FEPS should significantly outperform similar stocks in the same industry with low F-FEPS when the true firm profitability is subsequently revealed, for example, in subsequent earnings announcements. Third, if managers realize this phenomenon, they should manage their firm FEPS so that it remains low relative to other firms in the industry. One relatively easy way to achieve this goal is to engage in a stock split. Thus, we expect that firms with high F-FEPS should be more likely to engage in a stock split to lower their F-FEPS relative to other firms in the industry. If this 3 strategy is successful, we expect that both analysts and investors should be affected. In particular, we expect analysts to subsequently revise their earnings forecasts upward. As a consequence, the signed forecast errors and negative earnings surprises should be increased for split firms. In addition, this effect should be stronger for firms that have a low initial F-FEPS relative to the industry than for firms that have a high initial F-FEPS relative to the industry Our empirical results are consistent with all these hypotheses. We define a measure of cross-sectional anchoring, CAF, as the difference between the firm FEPS (F-FEPS) and the industry FEPS (I-FEPS), scaled by the absolute value of the later. First, we find that analysts earnings forecasts of firms with high CAF are more pessimistic than the forecasts of similar firms with low CAF. This result is consistent with analysts anchoring their forecasts on the industry median FEPS. Second, stock returns are significantly higher for firms with high CAF than for similar firms in the same industry with low CAF. The positive relationship between firm CAF and future stock returns cannot be explained by risk factors, the book-to-market or earnings-toprice effect, the accounting accruals effect, and price or earnings momentum. Moreover, earnings surprises are relatively more positive for firms with high CAF than for firms with low CAF. These results are consistent with investors anchoring their forecasts on the industry median FEPS. All these results are stronger when the industry FEPS is more stable and when market participants are less sophisticated.

Third, we find that the likelihood of conducting a stock split within a year is increasing when CAF is high. This result is consistent with the idea that managers realize the existence of anchoring in the financial markets and adjust their behavior to cater to this cognitive bias. Finally, firms with low CAF experience more positive revisions in earnings forecasts by analysts and more positive forecast errors after a stock split than firms with high CAF do. Consequently, 4 firms with low CAF experience more negative changes in earnings surprises after a stock split than do firms with high CAF. Our study contributes to the literature in at least three ways. First, it investigates whether anchoring, an important cognitive bias in the psychology literature, affects the decision making process of individuals in an important economic setting. This large sample test complements the previous research that was largely based on small sample experimental work. Although we focus on analysts earnings forecasts and price behavior in order to take advantage of a particularly rich data set, we expect that our results can be generalized in other settings as well. Second, the results of this study also enhance our understanding of the financial markets by providing new understanding of analyst and investor behaviors. Of particular importance, we show that the understanding of this cognitive behavioral bias may yield a trading strategy that generates abnormal returns. Specifically, our results suggest that a hedge portfolio that goes long on firms with high CAF and short on firms with low CAF can generate a monthly return of 1.2% with an Alpha of 0.75%. The profitability of this trading strategy remains significant for investment horizons that extend to at least 12 months. Finally, our results suggest a strategy based on stock splits for managers of firms with high EPS. This strategy can mitigate under-valuation and sometime generate over-valuation by influencing analysts earnings forecasts or revisions. The rest of this paper is organized as follows. In Sections 2 and 3, we discuss the theoretical foundations of our analysis and develop our research hypotheses. In Section 4, we discuss the sample and descriptive statistics. In Section 5, we present our empirical results. We conclude the paper in Section 6. 2. Prior Research on Anchoring 5 The prior literature (e.g., Kahneman and Tversky (1974)) suggests that individuals use cognitively tractable decisions strategies, known as heuristics, to cope with complex and uncertain situations. These heuristics reduce complex inferential tasks to relatively simple cognitive operations. Although these mental short-cuts help individuals in dealing with complex and uncertain situations, they may also lead to systematically skewed outcomes. The anchoring effect is one of the most studied cognitive biases that lead individuals to make suboptimal decisions. In their classical study, Kahenman and Tvesky (1974) suggest that individuals frequently form estimates by starting with an easily available reference value and then adjusting from this value. Although this approach may not be problematic per se, prior research shows that individuals typically fail to properly adjust their final estimates away from the salient but potential irrelevant starting point (the anchor). The seminal example involves spinning a wheel-of-fortune in front of the subjects and thus generating a number between 0 and 100. Kahneman and Tversky (1974) then ask the subjects their best estimates of the percentage of African nations in the United Nations. The obviously irrelevant random number

generates systematic bias in the estimation process. For example, the average estimate from subjects who observed a number equal to 10 was 25%. In contrast, the average estimate from subjects who observed a random number equal to 65 was 45%. This result has been replicated in many other experimental settings. For example, Kahneman and Tversky (1974) ask half of the subjects to estimate the value of 1x2x3x4x5x6x7x8 and ask the other half to estimate the value of 8x7x6x5x4x3x2x1. The average answers from two groups of subjects are 512 and 2,250, respectively. In a different setting, Russo and Shoemaker (1989) provide an anchor based on a constant (varying from 400 to 1,200) plus the last three digits of the subjects phone number. The two researchers then ask 6for an estimate of the year in which the Attila the Hun was defeated. Estimates were positively and significantly correlated with the anchor. More recently, Qu, Zhou, and Luo (2008) provide physiological evidence of the anchoring process based on event-related potential techniques (i.e., techniques that measure brain response stimulated by a thought or a perception). The prior literature has shown that anchoring is an extremely robust phenomenon. It influences various types of decisions in many different contexts, such as judicial sentencing decisions (e.g., Englich and Mussweiler, (2001)), personal injury verdicts (e.g., Chapman and Bornstein (1996)), estimation of likelihood of diseases (e.g., Brewer, Chapman, Schwartz and Bergus (2007)), job performance evaluation (Latham, Budworth, Yanar and Whyte (2008)) or real estate acquisitions (e.g., Northcraft and Neale (1987)). The accounting literature has also suggested that anchoring leads to biased outcomes. For example, Joyce and Biddle (1981) use experimental evidence to show that fraud estimation and audit planning are affected by the anchoring bias. Kinney and Uecker (1982) indicate that unaudited values in the financial statements influence analytical revenues. Biggs and Wild (1985) confirm the results in Kinney and Uecker (1982) and report that the anchoring bias would be moderated when additional audited information is available. Previous literature also suggests that it is particularly difficult to correct the anchoring bias. For example, the auditing literature suggests that the anchoring bias is prevalent, even among experienced professionals. Consistent with this view, Northcraft and Neale (1987) conclude (p. 95) that (1) experts are susceptible to decision bias, even in the confines of their home decision setting, and (2) experts are less likely than amateurs to admit to (or perhaps understand) their use of heuristics in producing biased judgments. Plous (1989) shows that task familiarity is not sufficient to avoid anchoring bias and that the effects of anchoring bias are not significantly influenced by the ease with which respondents can imagine the outcome (outcome availability), by the instructions to list the most likely path to the outcome (path availability), or by casting the problems in terms of the avoidance (rather than the occurrence). He also mentions that anchoring bias exists even after correcting for various social demand biases (i.e., the existence of expert opinion running against the initial anchor). Wright and Anderson (1989) consider the effect of situation familiarity on anchoring. They conclude (p. 68) that the anchoring effect is so dominant that increasing situational familiarity did not result in decreased anchoring. They find that monetary incentives can reduce anchoring but the effect is statistically

marginal (p<0.09). In contrast, Tversky and Kahneman (1974) find that payoffs for accuracy did not reduce the anchoring effect. Besides, Brewer, Chapman, Schwartz, and Bergus (2007) report that accountability does not reduce the anchoring bias in doctors prediction of infection. Whyte and Sebenius (1997) provide results suggesting that groups do not debias individual judgments. However, most studies mentioned above are based on small sample experimental approaches, and research based on large sample archival approaches is very limited. Ginsburgh and van Ours (2003) examine the career success of pianists who competed in the Queen Elizabeth Piano Competition. The order in which competitors play both across the week of the competition and on the night they perform (two competitors perform each night) affects judges ranking, even though the order is chosen randomly. The authors find that subsequent career success is significantly affected by the component of the competition ranking, which is related to the order of performance. George and Hwang (2004) postulate that investors are reluctant to bid 8the price high enough, when a stock price is at or near its highest historical value. Consistent with this intuition, they find that the stock price near to its 52-week high has predictive power for future returns. Campbell and Sharpe (2009) show that professional forecasters anchor their predictions of macroeconomic data such as the consumer price index or nonfarm payroll employment on the values of previous releases, which lead to systematic and sizeable forecast errors. However, all of these three studies mentioned above focus on the anchoring bias based on time-series information, but have not investigated the more general possibility of cross-sectional anchoring, which is the focus of our study. 3. Hypotheses Development and Research Design 3.1 Hypotheses development Given the documented robustness of the anchoring bias, we hypothesize that market participants such as sell-side analysts and investors should also be affected by the anchoring bias when they estimate the future profitability of a firm. This estimation is a complex task that involves a high degree of uncertainty, which makes market participants naturally anchor on salient information in their decision making. Prior research (e.g., Chapman and Johnson (2002)) suggests that anchors are most influential if they are expressed on the same response scale (dollars and dollars rather than dollars and percentages) and if they represent the same underlying dimension (width and width rather than width and length). A natural candidate in our setting is the industry median earnings per share (EPS). Since an analyst usually covers a group of firms within the same industry, this number is readily available and is naturally associated with the tasks on hand. For example, Zachs Investment Research states in the first line of a 9recent analyst report that median EPS is projected to drop 21.2%. The popular financial website, Investopedia.com, notes that earnings per share are generally considered to be the single most important variable in determining a shares price. The role of median values in anchoring is also consistent with the theoretical literature. For example, Tversky and Kahneman (1974) show in an experimental setting that subjects who receive the median estimates of other subjects tend to anchor on this median.

If the conjecture that market participants anchor on the industry median is correct, this should have important implications for the behaviors of analysts, investors and managers of publicly traded companies. First, if analysts anchor on the industry median forecasted EPS (IFEPS), their forecasts should be too close to this number. As a consequence, analysts are likely to underestimate the future realized earnings growth of firms with high F-FEPS (relative to the industry median FEPS). In other words, analysts give more optimistic earnings forecasts for stocks with low F-FEPS than similar firms in the same industry with high F-FEPS. Thus, signed earnings forecast errors are larger for low F-FEPS firms than for high F-FEPS firms in the same industry. This motivates our first hypothesis: H1: Signed forecast errors are larger for firms with low F-FEPS relative to their industry median FEPS than for firms with high F-FEPS relative to their industry median FEPS. Second, if investors anchor on the industry median FEPS or they are affected by the biased analysts earnings forecasts; their expectations of future profitability should also be biased. Firms with a high FFEPS relative to their industry median should suffer from low expectations regarding their future profits. Conversely, firms currently with low F-FEPS relative to their industry median should enjoy high expectations regarding their future profits. If this is the case, stocks with high F-FEPS should significantly outperform similar stocks in the same industry with low F-FEPS once the true profitability is revealed. This motivates our second hypothesis: H2: Controlling for risk factors, future stock returns for firms with high F-FEPS relative to their industry median FEPS are higher than for firms with low F-FEPS relative to their industry median FEPS. This prediction should be particularly true around subsequent earnings announcements. Third, if managers realize the presence of these biases among analysts and investors, they should manipulate the FEPS level so that it is low relative to other firms in the same industry. One easy way to achieve this goal is to perform stock splits. We expect that firms with high FFEPS relative to other firms in the industry would be more likely to engage in stock splits to lower their FEPS levels. This motivates our third hypothesis: H3: The probability of stock splits is larger for firms with high F-FEPS relative to their industry median FEPS than for firms with low F-FEPS relative to their industry median. If this strategy is successful, we also expect that both analysts and investors would be affected. In particular, we expect that firms with low initial F-FEPS relative to the industry FEPS before the stock splits should experience more positive revisions in earnings forecasts; 11more positive forecast errors, and more negative changes in earnings surprises after a stock split than do firms with high initial F-FEPS. 3.2 Research design

We use two basic approaches to investigate our hypotheses: regression analyses and portfolio sorts. One advantage of the regression approach is that it allows us to control easily for a host of potentially confounding effects. In contrast, the portfolio approach allows us to address various econometric issues (such as overlapping observations) and non-linearities more easily than in a regression framework. The portfolio approach also allows us to deal more easily with the bad model issue discussed by Fama (1996) and Mitchell and Stafford (2000). 3.2.1 Regression analysis Our first approach is based on the estimation of the following model:

Where Dep Var I,t represents our different dependent variables for firm i in period t. To test our first hypothesis, we consider FE, the analysts forecast errors, as the dependent variable. We define FE as the difference between the consensus EPS forecast (F-FEPS) and the actual EPS that is announced at the end of the fiscal year, scaled by the absolute value of the latter. F-FEPS is the mean of forecasted one-year-ahead earnings per share in the previous month from the I/B/E/S unadjusted summary historical file. EPS is the actual earnings per share for the next fiscal year end (reported in the IBES actual file). To test our second hypothesis, we compute two dependent variables at the end of each calendar month t. The first one is BHAR0:1, defined as the cumulative buyand-hold raw returns for firm i in the current month t.Our second variable is ECAR, defined as the three-day risk-adjusted cumulative abnormal returns around the most forthcoming earnings announcement over the next twelve months after the end of calendar month t-1. To test our third hypothesis, we define Spliti,t as an indicator variable that equals one if firm i carries out a significant stock split (e.g., one share is split into 1.5 or more shares) in month t and zero otherwise. Our main treatment variable, CAF, is a measure of cross-sectional anchoring bias. We define CAF as the difference between the individual firm forecasted EPS (F-FEPS) and the industry cross-sectional median of FEPS (I-FEPS), scaled by the absolute value of the latter. We define the 48 industries as in Fama and French (1997). In untabulated results, we have tried various CAF specifications and industry definitions and our results in this paper remain quantitatively and qualitatively similar. Aside from including a constant, we control for XK, a vector of K control variables. Specifically, we include the following control variables: the logarithm of market capitalization (Size), the logarithm of the book-to-market ratio (BTM), the accounting accruals (Accruals), the threeday abnormal return around the most recent earnings announcement date up to the beginning of month t (ESrecent ), and the time-series anchoring measure of EPS (TAF). We define

TAF as the difference between the individual F-FEPS and the most recently announced EPS,scaled by the absolute value of the latter. We use the lagged information in all control variables to ensure that the values of these variables are known by investors at the beginning of month t and to avoid any lookahead bias. We also control for past returns in our specifications. When FE, ECAR and Split are the dependent variable, we simply use the six-month buy-and hold return in the prior six months (Ret-6:0). However, when BHAR0,1 is the dependent variable, we control for Ret-7:-1 and Ret-1:0 because the prior literature has shown the presence of intermediate-term momentum and short-term reversal (e.g., Jegadeesh and Titman (1993, 2001)). In addition, we also control for the following three additional variables when FE is the dependent variable: Experience (the natural logarithm of one plus the average number of months covered by existing analysts), Breadth (the natural logarithm of the average number of stocks covered by existing analysts) and Horizon (the natural logarithm of one plus the number of months before next earnings announcement). If our hypothesis H1 is correct, the coefficient of CAF should be negative when FE is the dependent variable. In essence, when F-FEPS is low relative to I-FEPS, analysts may anchor on I-FEPS and issue overoptimistic forecasts. This would lead to low subsequent stock returns when market participants gradually revise and correct their optimism. In particular, we expect negative earnings surprises when the true earnings are announced. Therefore, if H2 is correct, we expect that the coefficient of CAF should be positive when BHAR0,1 is the dependent variable. We also expect that the coefficient of CAF should be positive when ECAR is the dependent variable, if investors realize their initial mistake when subsequent earnings are released. If H3 is correct, we expect that the coefficient of CAF should be positive when Split is the dependent variable. In other words, the managers would prefer to reduce the FEPS levels to avoid pessimistic earnings forecasts from analysts and undervaluation from investors. We use the Fama-McBeth (1973) approach when dependent variables (FE, BHAR, and ECAR) are continuous. In this case, we correct the standard errors for serial correlation and 14 heteroscedasticity using the Newey-West procedure. On the other hand, we use a logit specification when the dependent variable is binary (Split). We correct the standard errors of the estimated coefficients for heterokedasticity and simultaneous clustering of observations by firm and period (e.g., Cameron, Gelbach, and Miller (2009) and Peterson (2009)). 3.2.2 Portfolio Sorts. Our second approach is based on portfolio sorts. At the end of each calendar month, we first rank firms in quintiles according to market capitalization (size). Within each size group, we again sort all firms into five groups based on the CAF measure. We then observe the behaviors of different variables across all 25 portfolios. To test the first hypothesis, we consider FE as the dependent variable. To test the second

hypothesis, we consider two other variables, Alpha and ECAR, as dependent variables. Alpha is the intercept from the time-series regression based on the Fama and French (1993) thee-factor plus the Carhart (1997) momentum factor model as follows:

where Mkt Rf , SMB and HML constitute the Fama and French market, size and value factors, and UMD denotes the Carhart (1997) momentum factor. We use the one-month portfolio return as the dependent variable and we estimate the intercept (Alpha) for each of the 25 portfolios. To test the third hypothesis, we consider the time-series averages of stock-split ratios (SSR) as a proxy for the likelihood of stock splits. In each case, we form hedge portfolios that go long in firms in the highest CAF group and go short in firms in the lowest CAF group. We then test for the statistical significance of different dependent variables (FE, Alpha, ECAR, and SSR) in each hedge portfolio. 4. Sample and Descriptive Statistics 4.1 Sample selection Our basic sample consists of all NYSE, Amex and Nasdaq-listed common stocks in the intersection of (a) the CRSP stock file, (b) the merged Compustat annual industrial file, and (c) the Institutional Brokerage Earnings Estimates (I/B/E/S) unadjusted summary historical file for the period from January 1983 to December 2005. We obtain the data for the different systematic risk factors from Ken Frenchs website. To be included in the sample for a given month, t, a stock must satisfy the following criteria. First, its mean of analyst forecasts on the one-year-ahead (FY1) earnings per share (F-FEPS) in the previous month, t-1, should be available from the I/B/E/S unadjusted summary historical file. Second, its stock returns in the current month, t, and the previous six months, from t-6 to t-1, should be available from CRSP, and sufficient data should be available to obtain market capitalization and stock prices in the previous month, t-1. Third, sufficient data from CRSP and Compustat should be available to compute the Fama and French (1993) book-to-market ratio as of December of the previous year. In addition, stocks with share prices lower than five dollars at the end of the previous month, t-1, are excluded, as are the stocks with negative reported Compustat book values of stockholdersequity (Item #60) as of the previous month, t-1. This screening process yields 712,563 stockmonth observations or an average of 2,699 stocks per month. Before presenting our empirical results, we would like to emphasize the importance of using the I/B/E/S unadjusted data instead of the I/B/E/S adjusted data. The unadjusted FEPS is the actual reported value in analyst reports, while the adjusted FEPS has been adjusted for stock splits and stock issuance on the basis of the number of shares outstanding as of the latest data release day. Consequently, when we perform trading strategies based on FEPS, the results are only valid when the unadjusted FEPS is used

because this measure reflects the actual value that investors had historically perceived or observed at that time. The results are not valid when the adjusted FEPS is used because this measure contains ex post information reflecting stock splits, which could induce severe selection biases. The importance of using unadjusted I/B/E/S data has been recognized by many previous studies, such as Diether, Malloy and Scherbina (2002), and it has become the standard treatment in studying analysts forecast behaviors. 4.2 Sample characteristics Table 1 provides summary descriptive statistics of our sample. All independent variables mentioned above are either lagged by one month or computed based on public information as of the previous month, t-1, in order to guarantee that they are already known by investors at the beginning of each month and can be used to execute our trading strategies. Panel A of Table 1 reports the time-series averages of the cross-sectional means, medians, standard deviations and other statistics of the above variables. As shown in Panel A, all variables exhibit substantial variation, suggesting that the portfolio sorting strategies based on these characteristics should offer reasonable statistical power for our tests. The mean and median of firm size (Size) are $2.03 billion and $0.35 billion, respectively, which are much larger than the corresponding values for all CRSP stocks (an untabulated result). This reflects the fact that the sample of firms covered by I/B/E/S omits many small stocks. Since the return anomaly reported in this study is stronger for small stocks, the sample selection criteria actually bias against finding out our results. [Insert Table 1 Here] Table 2 reports the univariate correlation among these variables. CAF is negatively correlated with FE and positively with BHAR, ECAR and Split (although insignificantly). The correlations between control variables are low, suggesting that multicollinearity is not an important concern in our regressions. [Insert Table 2 Here] 5. Empirical Results 5.1 Anchoring and forecast errors We first investigate whether H1 is true. Results from our regressions are reported in Panel A of Table 3. We consider three different models with an increasing number of control variables. In the first column, we control for Size, BTM and RET-6:0. In the second column, we add Accruals and ESrecent into the control variables. Finally, in the last column, we also control 18for E/P, TAF and other three variables specific to the FE regressions (Experience, Breath and Horizon). Consistent with H1, CAF is significantly negative in all three models. The effect is economically significant. For example, an increase of CAF by one standard deviation increases FE by approximately 13.2% of its mean. The effect is also statistically significant with tstatistics ranging from -2.42 to -4.97. As robustness checks, we consider two alternative dependent variables in our regressions.

In the first alternative specification, we use the consensus long-term growth rate forecasts (LTG) as reported in the IBES unadjusted summary file. In the second one, we use the revision of longterm growth rate (RLTG). RLTG is estimated as the slope coefficient (ti

) in the time-series regression of over the next twenty-five months beginning from the previous month, which measures the monthly adjustment of LTG. Consistent with the results tabulated in Panel A of Table 3, CAF is significantly negative in the first case (with a t-statistic equal to -11.94) and positive in the second case (with a t-statistic of 2.77). In other words, the results in Table 3 show that analysts anchor on I-FEPS when they forecast earnings and thus are optimistic for firms with low F-FEPS. These additional untabulated results show that analysts are subject to a similar anchoring phenomenon when they forecast long-term growth rates of earnings and that they gradually correct their initial forecast errors over time. [Insert Table 3 Here] Panel B of Table 3 provides the results of the portfolio sorts, based on size (from G1 to G5) and on CAF (from E1 to E5). The last column of the table reports the results of the partitions based on CAF for firms of all sizes pooled together. As we go from E1 (the portfolio of firms with the lowest CAF) to E5 (the portfolio of firms with the highest CAF), the average value of FE is monotonically decreasing. The difference between the average value of FE in E5 and E1 is statistically significant with a t-statistic equal to -5.28. The other five columns report the mean FE for the different portfolios based on size and CAF. For all levels of CAF, FE is increasing as firm size is decreasing. The effect is monotonic in virtually all cases (except between G4 and G5 for E4). More importantly for our purpose, FE is decreasing in all size groups when CAF is increasing. However, both the magnitude and the statistical significance of the difference between firms with high CAF and low CAF are decreasing when the firm size is increasing. For example, the magnitude of the difference is decreasing in absolute value from -0.253 to -0.016. Similarly, the t-statistic of the difference is decreasing in absolute value from -5.82 to -1.92 from G1 to G5. Untabulated results indicate that we reach similar conclusions if we use a similar procedure to sort LTG and RLTG based on size and on CAF. The results from portfolio sorts are therefore consistent with H1. 5.2 Anchoring and one-month ahead BHAR We then investigate if H2 is true. Panel A of Table 4 presents the results of a regression of a onemonthahead BHAR on CAF and our control variables. For all three models, CAF is significantly positive with t-statistics ranging from 3.14 to 3.59. The economic effect is such that increasing CAF by one standard deviation increases BHAR by approximately 18.6% of the mean value of BHAR. [Insert Table 4 Here]

Panel B of Table 4 provides the results of the portfolio sorts, based on size (from G1 to G5) and based on CAF (from E1 to E5). For each portfolio, we estimate a time-series regression based on the Fama-French and Carhart four-factor model for each portfolio. We report the intercepts, Alphas, of the different portfolios in Panel B of Table 4. The last column of the table reports the results of the partitions based on CAF for firms of all sizes pooled together. As we go from E1 (the portfolio of firms with low CAF) to E5 (the portfolio of firms with high CAF), the values of Alphas are monotonically increasing. The difference between the values of Alpha in E5 and E1 is statistically significant with a tstatistic equal to 3.89. The value of Alpha for the hedge portfolios monthly returns (long E5 and short E1 at the same time) is 0.7%. The other five columns report the intercepts for the different hedge portfolios based on size and CAF. The average values of the abnormal returns (Alpha) are significantly positive for all levels of size. However, both the magnitude and the statistical significance are decreasing when the firm size is increasing. For example, the t-statistic of the difference is decreasing from 5.39 to 2.10 from G1 to G5. Similarly, the magnitude of the difference is decreasing in absolute value from 1.417 to 0.348. Untabulated results indicate that we obtain similar results if we use either value-weighed or equal-weighted portfolio returns instead of the intercepts of the time-series regression (Alpha). The tabulated results are based on dependent sorts of the firms based on Size and CAF. These dependent sorts ensure that the number of firms is the same in all portfolios. Untabulated tests indicate that we find similar, if not stronger, results, when we use independent sorts and allow for the number of observations to vary across portfolios. Following Zhang (2006), we also replace Size with alternative proxies that may be correlated with information uncertainty, such as Size, V/P and CAF or Size, FE scaled by price and CAF. 21firm age, share price, analyst coverage, and institutional holdings. We find similar (untabulated) results as those reported in Table 4. [Insert Figure 1 Here] Table 4 focuses on the one-month-ahead return. However, the effect of CAF is not limited to the onemonth horizon. Figure 1 plots the average cumulative raw returns at the monthly intervals of the hedging strategy by buying the highest CAF decile portfolio and selling the lowest CAF decile portfolio. It reveals that the hedging portfolio returns to the CAF strategy grow consistently within at least the first twelve months after portfolio formation. To investigate this possibility, we re-estimate a model similar to the one reported in the last column of Panel A of Table 4 but we use returns cumulated over 3, 6 and 12 month, respectively. The intercepts (untabulated) are equal to 0.121, 0.227 and 0.484 with t-statistics of 1.96, 2.13 and 2.21, respectively. Although the cumulated abnormal returns grow at a decreasing rate, they do not show any reversal over the next thirty-six months. This distinguishes the CAF anomaly from the momentum effect, for which Jegadeesh and Titman (2001) find a dramatic reversal of returns to the momentum strategy after one year.

5.3 Anchoring and market reaction around earnings announcements Having found that future returns and CAF are positively related, we focus next on returns around earnings announcements. Panel A of Table 5 presents the results of a regression of the earnings announcement return (ECAR) on CAF and other control variables. For all three models, CAF is significantly positive with t-statistics ranging from 4.08 to 4.36. The economic effect is such that increasing CAF by one standard deviation increases ECAR by approximately 100% of the mean value of ECAR.[Insert Table 5 Here] Panel B of Table 5 provides the results of earnings surprises (ES) from portfolio sorts, based on size (from G1 to G5) and based on CAF (from E1 to E5). For each portfolio, we estimate the average market reaction around the earnings announcements. The last column of the table reports the results of the partitions based on CAF for firms of all sizes pooled together. As we go from E1 (the portfolio of firms with low CAF) to E5 (the portfolio of firms with high CAF), the average values of earnings surprises are increasing. The difference in the values of earnings surprises between E5 and E1 is statistically significant with a t-statistic equal to 6.71. The average return of the hedge portfolio is 0.37% over the three day period around the earnings announcement and the returns of the hedge portfolios are positive for all size groups. However, both the magnitude and the statistical significance are decreasing when the firm size is increasing. For example, the magnitude of the difference in three-day earnings surprises is decreasing from 0.51% to 0.12%. Similarly, the t-statistic of the difference is decreasing from 5.07 to 1.16 from G1 to G5. Overall, the returns surrounding earnings announcements of the hedge portfolios are significant for the three smallest size quintiles and in the pooled sample. 5.4 Anchoring and stock splits We next investigate if H3 is true. But before doing so, we examine the time-series behavior of forecasted earnings per share (FEPS) and aggregate earnings. Figure 2 indicates the existence of a stable pattern in the cross-sectional distribution of nominal forecasted EPS (FEPS). Untabulated results also indicate that this phenomenon also exists in the nominal realized earnings per share (EPS). The crosssectional median of FEPS rarely deviates away from a small range bounded by $1.5 and $2 in our sample period from 1983 to 2005. In contrast, the median of forecasted total earnings (TFE) in the crosssection almost tripled from US$14 million to US$37 million during the same time period. [Insert Figure 2 Here] This provides an indirect test of this hypothesis. These differences in time-series are consistent with the idea that firms manage their nominal earnings per share around an optimal level. Panel A of Table 6 presents the results of logit regressions of Split on CAF and our different control variables. For all three models, CAF is significantly positive with t-statistics ranging from 2.59 to 2.86. The economic effect is such that increasing CAF by one standard deviation increases the odd ratio of a stock split by approximately 5.0%.

[Insert Table 6 Here] Panel B of Table 6 provides the results of the portfolio sorts, based on Size (from G1 to G5) and on CAF (from E1 to E5). For each portfolio, we compute the average stock split ratio (SSR). The last column of the table reports the results of the partitions based on CAF for firms of all sizes pooled together. As we go from E1 (the portfolio of firms with low CAF) to E5 (the portfolio of firms with high CAF), the average value of SSR is monotonically increasing. The difference between the average value of SSR in E5 and E1 is statistically significant with a tstatistic equal to 8.48 in the pooled sample. Results also indicate that for each value of CAF, the stock split ratio is increasing monotonically with the firm size. More importantly for our purpose, the difference in SSR between E1 and E5 is significant in all size groups. However, both the magnitude and the statistical significance of this result are decreasing when the firm size is increasing. For example, the magnitude of the difference is decreasing from 0.098 to 0.166. Similarly, the t-statistic of the difference in SSR is decreasing from 9.31 to 4.87. We reach a similar conclusion if we use the number of stock split instead of SSR as a dependent variable (untabulated). 5.5 Consequences of the stock splits Our hypothesis H3 predicts that when the level of FEPS is reduced relative to the industry median, the ex ante undervaluation of high CAF stocks would be mitigated since their FEPS levels after stock splits are relatively closer to their anchors than before stock splits. Similarly, if the ex ante CAF is already low, stock splits may have a chance to generate overvaluation of their stocks. This prediction is consistent with the positive announcement effects and the ex post performance of stock splits documented in the previous literature. Nevertheless, to a certain extent, the announcement effect and the ex post performance of stock splits are not desirable measures to capture the CAF effect since the stock splits, in addition to reducing FEPS levels, also involve changes in other factors, such as liquidity (Angel, 1996). To avoid complications from alternative explanations of stock split announcement effects, we examine other consequences of stock splits, such as analyst forecast revisions (Panel A of Table 7), analyst forecast errors (Panel B of Table 7) and earnings surprises (Panel C of Table 7). To do so, we use a difference in difference approach. We first identify firms that carry out significant stock splits (e.g., one share is split into 1.5 or more shares) in each month. In Panels A and B, we match these firms with firms that do not engage in a stock split and have similar size, book-to-market ratio, forecast errors and CAF (we use the value for the month prior to the stock split to match firms). We then compute the differences in forecast errors (Panel A) and in forecast revisions (Panel B) between the firms that engage in a stock split and the median value of the matched firms that do not engage in a stock split. In Panel C, for each firm and each month, we compute the change in ex post and ex ante earnings surprises (ES). We match firms that engage in a stock-split with

firms that do not by size, book-to-market ratio and CAF. We report the difference in changes in earnings surprises between the firms that engage in a stocksplit and the median value of the matched firms that do not. We next repeat our procedure of double sorts based on size and CAF. [Insert Table 7 Here] Panel A of Table 7 shows that, with two exceptions, there is a positive change in forecast revisions for firms after a stock split compared with firms that did not engage in a stock split. In 26 28 out 30 cells, the differences of forecast revisions between split firms and non-split firms are positive. More importantly for our purpose, the last column that pools all size together indicates that the effect is more significant for firms with low CAF than for firms with high CAF. For example, the differences decrease monotonically from 0.075 to 0.001 as the CAF increases from E1 to E5. This result suggests that the effect of stock split concentrates on firms with low ex ante CAF. In addition, the difference in forecast revisions between split firms and matched non-split firms for the entire sample is 0.029 with a t-statistic of 16.78, and they are statistically significant in all five size groups. Panel B shows that, when the ex ante CAF level is low, there is a positive change in forecast errors for firms after a stock split compared with firms that did not engage in a stock split. However, this effect is weaker as the CAF is increasing and is even negative for portfolios in which CAF is the highest (E5). The difference in forecast errors between split firms and matched non-split firms for the entire sample is 0.017 (the t-statistic is 5.53), and they are statistically significant in four out of five size groups (the tstatistic is 1.54 in the second smallest size group). Panel C shows that there is a negative change in earnings surprises after the stock split compared with firms that did not engage in a stock split. In 29 out 30 cells, the differences in earnings surprises changes between split firms and non-split firms are negative. More importantly for our purpose, the effect is more significant for firms with low CAF than for firms with high CAF, especially in three smallest size groups. 5.6 Cross-sectional partitions. 27 Our results in the previous sub-sections are consistent with our hypotheses H1-H3 and suggest that analysts and investors tend to anchor on the industry median FEPS. Before concluding this study, we investigate two additional issues. The first one is that we expect that the anchoring effect should be stronger when the anchor is more stable. To test this conjecture, we re-estimate our different models from Panel A of Tables 3 to 6 but we split the sample between two sub-groups based on the stability of the anchor. We use the full specification reported in the last column of each table. The stability of the anchor is measured by the coefficients of variation (CV) of I-FEPS corresponding to a period of previous 24 months (lower CVs indicate more stable anchors). Results are reported in Table 8 (the different control variables are included but not tabulated). In all subsamples, CAF has the predicted sign and is significant at the 5%

level or better (except when FE is the dependent variable and the anchor is unstable, in which case the significance is at the 10% level). More importantly for our purpose, CAF is economically and statistically more significant in the sub-samples with more stable anchors. In fact, the difference in coefficients between the stable and unstable samples is significant at the 5% level or better in all cases. [Insert Table 8 Here] Finally, we examine the effect of the sophistication on the degree of anchoring bias. To do so, we split the sample based on the sophistication of the market participants. For analysts, we consider the size of the employers. The prior literature (e.g., Hong and Kubik (2003)) has suggested that analysts working for large brokers produce more informative forecasts. For investors, we consider the percentage of institutional ownership. The prior literature has also 28suggested that institutional investors are more sophisticated than retail investors (Bartov, Radhakrishnan, and Krinsky (2000), and Bhusan (1994)). Results indicate that the effect of anchoring is weaker when market participants are sophisticated than when they are not. The effect is economically and statistically more significant in the sub-samples dominated by the unsophisticated participants than in the sample dominated by the sophisticated participants. The difference between the coefficients across the subsamples is significant at the 5% level or better for the institutional investors. The difference is significant at the 10% level for the analysts. 6. Conclusion We consider the effect of the anchoring bias on market participants such as sell-side analysts and investors, a topic that has not been extensively investigated by the prior literature in accounting and finance. We hypothesize that market participants are affected by the anchoring bias when they estimate the future profitability of a firm. Our empirical results are consistent with this hypothesis. First, we find that analysts earnings forecasts of firms with low forecasted EPS relative to the industry median forecasted EPS are more optimistic than the forecasts for similar firms with high forecasted EPS relative to the industry median forecasted EPS. This result is consistent with analysts anchoring their forecasts on the industry median forecasted EPS. Second, future stock returns are significantly higher for firms with high forecasted EPS relative to the industry median forecasted EPS than for similar firms in the same industry with low forecasted EPS relative to the industry median forecasted EPS. The positive relationship between firm FEPS and future stock returns cannot be explained by risk factors, the book-tomarket or earnings-to-price effect, price or earnings momentum, or the accounting accruals effect. In addition, earnings surprises are more positive for firms with high forecasted EPS29relative to the industry median forecasted EPS than for firms with low forecasted EPS relative to the industry median forecasted EPS. Third, we find that the likelihood of doing a stock split within a year is increasing when forecasted EPS relative to the industry median forecasted EPS is high. All these results are stronger when the industry

medians are more stable and when market participants are not sophisticated. Finally, stock split firms with low forecasted EPS relative to the industry median forecasted EPS experience more positive earnings forecasts revisions by analysts, more positive forecast errors than they do for their non-stocksplit firms and more negative changes in earnings surprises after a stock split than do firms with high forecasted EPSrelative to the industry median forecasted EPS. 30