Net Income Measurement, Investor Inattention, and Firm Decisions

Abstract

This paper studies the interaction between investor inattention and firms' capital allocation decisions by exploiting an accounting rule change that requires publicly traded firms to incorporate changes in unrealized gains and losses (UGL) from equity securities into net income. We build a model with risk-averse investors who can be attentive or inattentive and managers who choose how much to invest in financial assets. The model makes two main predictions. First, with inattentive investors, the rule change will cause firms' stock prices to react more strongly to changes in UGL. Second, we identify conditions under which the rule can lead to a higher stock price discount because of higher perceived residual uncertainty, and managers respond by cutting investment in financial assets. We use US insurance company data to test these predictions. We find that insurers' stock returns react more strongly to changes in UGL on equity securities after the rule change, and more so for firms with low analyst coverage. Using a difference-in-differences approach, we find that by 2020, public insurance companies cut investments in publicly traded stocks by almost 20%. Our results highlight the impact that investor inattention has on firms' stock prices and resource allocation decisions.