- Loss aversion, where people dislike losses more than they like gains, is a behavioral bias that affects investor decision-making.
- A forthcoming study analyzes how investors react to negative and positive changes in firms’ product warranty payments, using the concept of loss aversion.
- Investors interpret increasing warranty payments as a signal of “quality losses” and decreasing warranty payments as a signal of “quality gains,” resulting in an asymmetric stock return response.
- Additional evidence supports the notion that losses loom larger than gains in financial markets, such as investors reacting more strongly to dividend cuts than dividend increases.
- Experimentation and analysis of analyst reports validate warranty payments as a communication of product quality information to stock market participants.
- Advertising spending and industry concentration can moderate the impact of changes in warranty payments on investor valuation.
- Offering warranties does not necessarily ensure high firm value, and managers should invest in product quality rather than myopically relying on warranties to boost sales.
People have a greater aversion to losses than the pleasure they derive from gains. This psychological bias, known as loss aversion, plays a significant role in investor decision-making. Researchers, Didem Kurt, Koen Pauwels, and Shuba Srinivasan, co-authored a paper for the International Journal of Research in Marketing concerning loss aversion and its impact on investor reactions to product warranty payments.
The study applies the prospect theory, developed by Daniel Kahneman and Amos Tversky, to product and financial markets in order to analyze investor responses to negative and positive changes in firms’ product warranty payments. The authors hypothesize that investors perceive increasing warranty payments as a sign of “quality losses” and decreasing warranty payments as a sign of “quality gains.” This asymmetric perception is likely to result in an asymmetric stock return response.
The phenomenon of loss aversion has been observed in various real-life scenarios. For example, sellers often overprice items because they place greater value on possession, while buyers are more cautious in their purchasing decisions. In financial markets, evidence suggests that investors react more strongly to dividend cuts than dividend increases. Investors also tend to hold on to losing stocks longer than winning stocks, a behavior called the disposition effect. However, this effect is less pronounced among sophisticated and wealthy investors.
The study conducted by Kurt, Pauwels, and Srinivasan focuses on how the stock market collectively responds to changes in firms’ product warranty payments. They conducted an experimental survey with potential investors, where participants were presented with two conditions: high warranty payments and low warranty payments. The participants who perceived higher warranty payments as a signal of lower product quality were less likely to invest in the company’s stock. This experiment validates the argument that warranty payments communicate relevant product quality information to stock market participants.
The authors also examined analyst reports to further support their findings. They theorized that higher warranty payments in the current period would predict a greater discussion of quality-related issues in analysts’ reports in the upcoming period. The analysis of over 66,000 analyst reports confirmed this hypothesis, demonstrating a positive correlation between current period warranty payments and future reports discussing quality-related issues.
The study examined 666 warranty offering firms listed on the US stock exchanges from fiscal years 2010 through 2016. By estimating a first-order autoregressive model of warranty payments, the researchers were able to capture unanticipated changes in warranty payments. The results showed that stock returns decrease with an unanticipated rise in warranty payments, indicating an asymmetric investor reaction to increasing warranty payments as “quality losses” versus decreasing warranty payments as “quality gains.” A one standard deviation increase in unanticipated rise in warranty payments was associated with a 2.5 percentage points lower annual stock returns for the average firm in the sample.
The study also considered other factors that may influence investors’ interpretation of changes in warranty payments, such as advertising spending, research and development (R&D) spending, and industry concentration. The results showed that increased advertising spending reduced investors’ sensitivity to the negative news conveyed through rising warranty payments, while R&D spending did not have the same effect. Additionally, a positive relationship was found between stock returns and declining warranty payments when an industry became less concentrated, indicating that investors reward firms with improved product quality in highly competitive markets.
It is worth noting that offering warranties does not guarantee high firm value. Warranty offering firms with rising warranty claims actually had lower firm value compared to non-warranty offering firms. As a result, managers should invest in product quality rather than solely relying on warranties to boost sales. Investors should also consider changes in the industry’s competitive landscape when interpreting changes in a firm’s warranty claims.
In conclusion, loss aversion plays a significant role in investor decision-making. Investors react differently to negative and positive changes in firms’ warranty payments, perceiving them as “quality losses” and “quality gains” respectively. This asymmetric response affects stock returns and can be moderated by factors such as advertising spending and industry concentration. Offering warranties does not guarantee high firm value, so managers should focus on investing in product quality. Investors must consider the competitive landscape when interpreting changes in warranty claims to assess the impact on stock returns.
