Investor sophistication and patterns in stock returns after earnings announcements

This study tests whether the observed patterns in stock returns after quart erly earnings announcements are related to the proportion of firm shares he ld by institutional investors, a variable used by prior research to proxy f or investor sophistication. Our findings show that the institutional holdin gs variable is negatively correlated with the observed post-announcement ab normal returns. Our findings also show that traditional proxies for transac tion costs (i.e., trading volume, stock price) as well as firm size have li ttle incremental power to explain post-announcement abnormal returns when i nstitutional holdings is an explanatory variable. If institutional ownershi p is a valid proxy for investor sophistication, these findings suggest that the trading activity of unsophisticated investors underlies the predictabi lity of stock returns after earnings announcements. However, tests evaluati ng the validity of institutional holdings as a proxy for investor sophistic ation yield only mixed results. This calls for caution in interpreting our findings.