Do Investors Misunderstand Loss Persistence? Evidence from Institutional Investors

Motivated by the shareholder heterogeneity literature which argues that institutional investors are different in expertise, sophistication and information processing capabilities, we revisit the research question - whether investors misunderstand loss persistence. We try to answer this question from the perspective of institutional investors using U.S. data over the 1992-2015 period. We find that our defined sophisticated institutional investors adjust their shareholdings of loss-making firms based on forecasted earnings in the next year as they appear to understand loss persistence ex ante. On the contrary, ex ante loss reversal has no significant impact on the changes of the shareholdings owned by their counterparts. The results are robust to an alternative measure of institutional ownership as well as to the consideration of trading costs. Moreover, we document that changes in the sophisticated institutional ownership are associated with cumulative abnormal returns around the forthcoming earnings announcements, suggesting that the general market participants may not understand the rational trading behaviour of sophisticated institutional investors due to the mixed trading patterns amongst institutional investors until the next earnings announcement. Our study sheds light on why a profitable arbitrage opportunity exists for loss-making firms as documented in Li (2011) and Jiang, Soares and Stark (2016).