Investor Sophistication and Market Earnings Expectations

This paper investigates whether sophisticated investors rely more on analyst forecasts than on time-series model forecasts in forming expected earnings. Specifically, I investigate if earnings-announcement-related returns are more closely associated with analyst (SRW) forecasts for firms for which the marginal investor is more (less) likely to be sophisticated. My proxies for investor sophistication are institutional ownership, analyst following, and firm size (Atiase [1985], Hand [1990]). For a sample of 89,246 firm-quarter observations over 1980-1995, I find that the weight placed on the analyst (SRW) forecast is increasing (decreasing) in my proxies for investor sophistication. These results are consistent with an association between investor sophistication and the relative weight placed on analyst and SRW forecasts in forming expected earnings. Further analysis indicates that neither forecast availability (as captured by publication in The Wall Street Journal) nor forecast accuracy can account for these findings.