Journal of Systems Science and Information
Aug., 2015, Vol. 3, No. 4, pp. 301–320
DOI: 10.1515
/jssi-2015-0301
Earnings Surprise, Portfolio Inertia and Stock Price Volatility
Shunwu HUANG
School of Economics, Hefei University of Technology, Hefei 230601,China
E-mail : bchsw2012@163.com
Wang CHAN G
School of Economics, Hefei University of Technology, Hefei 230601,China
E-mail : changwang126126@126.com
Lan ZHENG
School of Economics, Hefei University of Technology, Hefei 230601,China
E-mail : lzheng28@gmail.com
Abstract From the perspective of the mediation effect, this paper investigates whether institutional
investors adjust their portfolios according to the listed companies earnings surprise. We find that the
portfolio adjustments by institutional investors exert the mediation effect on the relationship between
earnings surprise and stock price volatility. Institutional investors actively manage their portfolios
in the rising market, which induces the stock price volatility; while they less adjust their portfolio
in the falling market, the volatility declines. This paper helps understand the role of institutional
investors in the fluctuation of stock prices, and provides a new basis for decision making of regulatory
administration.
Keywords institutional investor; earnings surprise; mediating effect; portfolio inertia; stock price
volatility
1 Introduction
Stock price volatility is one of the central issues of concern in academia and industry.
Particularly, there are ups and downs of the “roller-coaster” prices in the Chinese A-share
stock market, and its magnitudes of volatility are huge enough to rarely present in the world.
Although the striking fluctuations on share prices provide some opportunities for investors,
they are more accompanied by risks that make investors suffer heavy losses on a general basis,
which seriously constrains the healthy development of Chinese capital market. In literature, a
number of studies have addressed the sources of price volatility and ways to reduce volatility,
however, no unanimous conclusion is reached. Clearly, it is important to examine this issue
in-depth from new perspectives.
Under the strategic guidance of the CSRC (China Securities Regulatory Commission) to
develop institutional investors in a super-normal scale, institutional investors have been develop-
ing at a fast-rising rate in China’s securities market. It becomes more common for institutional
Received September 23, 2014, accepted February 15, 2015
Supported by National Social Science Foundation of China (14BJY181)
302 HUANG S W, CHANG W, ZHENG L.
investors represented by fund companies to dominate the top 10 major shareholders of listed
companies, which leads to the structural change in the Chinese capital market investment, that
is, the shift from individual investors to institutional investors. By the end of 2012, there are
57,135 institutional investor accounts that own 12 trillion Yuan of the A-share capitalization,
which accounts for 66% of market values in A-share circulation. Generally, institutional in-
vestors manage their investment assets by means of portfolios. According to the provisions
of Interim Measures for the Administration of Securities Investment Funds (1997), concerning
fund portfolio, the number of shares that a fund can hold must not exceed 10% of the fund
net asset value. Therefore, in theory, institutional investors portfolio adjustments may have a
significant impact on related individual stock prices.
In order to achieve optimal portfolios and maximum profits, institutional investors make ef-
forts to search all the public and private information, and decide whether to adjust portfolios
[1]
.
As one of the most important accounting information, earnings surprise is the deviation from
investors’ expectations of actual earnings of the company, and its size depends on not only
the relevance of past financial information and the future earnings, but also the accuracy of
investors’ expectations. When a company releases an earnings announcement, earnings surprise
may arise because previously uncertain information becomes certain, which, in turn, generates
new uncertainties. Essentially, earnings surprise is ever-changing new information, which re-
veals the uncertainty of the information. Compared to the individual investors, institutional
investors are usually considered as “sophisticated investors”. They appear to have advantage
of gathering, processing, and utilizing information with a stronger investment sense and more
specialized investment vehicles. Taking profits and risks into account, institutional investors
adjust their portfolios, which is the result to hedge the uncertain information.
It is reasonable to examine the impacts of investors’ portfolio adjustments on the relationship
between earnings surprise and stock price volatility from the perspective of the mediation effect .
As shown in Figure 1, earnings surprise in itself does not directly impact the share prices; while,
in the form of a message into the market, it indirectly leads to share price volatility by means
of investors. In other words, the investors’ trading is indispensable intermediary step between
earnings surprise and stock price volatility, for which their trading characteristics (activeness
or inertia) is essential. In Figure 1, the investors’ trading is an intermediary variable, and its
magnitudes determine the effects of earnings surprise on stock price volatility. With regard to
earnings surprise of listed companies, institutional investors take actions on decisions of whether
and how to adjust their portfolios, which in turn, leads to the possible impact on the share
prices. In view of the dominance of institutional investors in China’s capital market during the
sample period, this paper focuses on the portfolio adjustments by institutional investors as an
intermediary variable to expand research.
Message
Earnings
surprise
Activeness/
inertia
Figure 1 Relationship between earnings surprise, portfolio adjustment and stock price volatility
Earnings Surprise, Portfolio Inertia and Stock Price Volatility 303
Based on regular announcements data from A-share listed companies over the period 2007
to 2012, this study investigates whether earnings surprise of listed companies contributes to
institutional investors’ portfolio adjustments from the perspective of mediation effects, which
in turn, results in the stock price volatility. The research indicates the existence of correspond-
ing mediation effect: In the face of earnings surprise, institutions investors actively adjust their
portfolios in the rising market to amplify the share price volatility; while in the falling mar-
ket, institutional investors barely adjust their portfolio positions, and to some extent, exhibit
portfolio adjustment inertia, which in turn, reduce the stock price volatility.
The contributions of this paper are fourfold. First, we propose the concept of “portfolio
adjustment inertia” for the first time. Second, this study focuses on individual stocks rather
than the market (index) level, which is more in line with institutional investors dominance
in the capital market during the sample period. Third, this paper examines the relationship
between earnings surprise, institutional investors and stock price volatility from the perspective
of mediation effects, which has important implications for in-depth understanding of stock
price fluctuations in Chinese capital market, as well as of the investment characteristics of
institutional investors. Fourth, this study finds the different effects that institutional investors
manage their portfolio adjustments on stock price volatility in the rising and falling stock
markets, which is quite different from previous literature of single conclusion (“aggravation” or
“stability” theory). Therefore, this paper is a essential complement to the existing literature.
The structure of this paper is organized as follows. Section 2 reviews the literature on
the connection among information uncertainty, institutional investor and stock price volatility.
Section 3 presents four main hypotheses, describes data selection criteria, and provides definition
of the variables. In Section 4, we present descriptive statistics of variables, introduce the
construction of the models, and also report regression results. Section 5 provides a summary
of our findings and some concluding remarks.
2 Literature Review
We review the existing literature from the connection among information uncertainty, in-
stitutional investor and stock price volatility.
The first is the relationship between information uncertainty and stock price volatility.
There is evidence that information for the fluctuation of asset prices is asymmetric. [2] inves-
tigated the conditional covariance of stock returns using EGARCH model for the period July
1926–December 1990, and found the response of volatility to bad news is strong while to good
news is weak. [3] constructed a model to show that investors react more seriously to bad news
than to good news and also dislike assets for which information is uncertain. These effects
induce ambiguity premia that depend on idiosyncratic risk. This conclusion is supported by
[4]. He finds, as the uncertainty is increasing, investors place greater weight on bad earnings
news.
Scholars study the effects of ambiguous information on stock price volatility from the per-
spective of earning announcement. Using European exchange listed firms from 1997 to 2010,
[5] found that information uncertainty played an important role in earning announcement
drift: information uncertainty is positively related to future abnormal return and abnormal
304 HUANG S W, CHANG W, ZHENG L.
trading volume. Based on Chinese listed firms, [6] discussed the existence and persistence of
Post-Earnings-Announcement Drift (PEAD), and found that information quality affect PEAD
through two ways: The indirect way is that, since most stocks with poor information quality
are in the high earnings surprise group, information quality affect PEAD through earnings
surprise; the direct way is that portfolio with poor information quality has a high abnormal
return after earning announcement. [7] used random walk model to calculate earnings surprise
and found that investors information demand prior to earnings announcements has no effect
on the relationship of contemporary abnormal return and earning surprise, but the demand in
the following earnings announcements has negative effect. [8] constructed a model to study the
effects of risk and ambiguity on optimal portfolios and equilibrium asset prices, and showed
that the desire of investors to hedge ambiguity leads to portfolio inertia and excess volatility.
[8] did a valuable theoretical work, but the work just views portfolio inertia and asset price as
a result of ambiguous information. We further discuss the role of portfolio adjustment in the
stock price volatility and support it with empirical evidence.
The second is the relationship between institutional investor and market volatility. Do in-
stitutional investors lessen or strengthen the market volatility? The answer is not clear, though
more research support the former. Using data from American stock market between January
1, 1988 and December 31, 1996, [9] came to conclusions that abnormal return and abnormal
turnover are both positively related to the percentage of institutional ownership. These results
are consistent with positive feedback herding behavior of some institutions. Therefore, the in-
stitutions play a more important role in market volatility. [10] found that the trading of better
informed short-term institutional investors forecasts future stock returns and is also positively
related to future earnings surprises, while long-term institutions trading did not. So, the short-
term trading of institutions may intensify the stock price volatility. [11] conducted a simple
theoretical model to analyze the impact of institutional herding on asset prices and showed that
the herding positively predicts short-term returns, but negatively predicts long-term returns.
[1] concluded that institutional owners decrease their positions prior to earnings announcements
in order to avoid losses, and increase their positions of which underreact to the earnings an-
nouncements in the post-announcement period. The changes in institutional positions make
a difference to the abnormal return before and after the earnings announcements. Based on
high-frequency data, [12] proved that the volatility of the institutional stockholding ratio is the
main source of index volatility and had significant effect on general corporate investors and
important individual investors. [13, 14] shared the same points that institutional investor do
not stabilize the market, but facilitate the market volatility.
Minority researchers sustained that institutional investors stabilize the market. [15] investi-
gated the differences in the holdings of institutional investors and individual investors between
March and November 2000. They found institutional investors held stocks with less return
volatility than individual investors and performed better. According to this view, institutional
investors lower the market volatility. Based on Shanghai stock market from 2001 to 2004, [16]
used non-parametric test and found there is a significant negative relationship between institu-
tional investor holdings and stock volatilities after controlling the firm size. This conclusion is
questionable, as the size and number of Chinese institutional investors are not big enough to
Earnings Surprise, Portfolio Inertia and Stock Price Volatility 305
make an impact on the whole market in that period.
The third is the existence and cause of portfolio inertia. Whether investors’ portfolio adjust-
ment is inert or not, the answer is not clear. Based on research into personal pension account,
[17] found that household trading was highly inactivity and showed a certain degree of portfolio
inertia. [18] used transaction data from representative sample of US individuals and families to
document the extent of household portfolio inertia which contribute to stock market instability.
However, [19] investigated the 66,465 households of accounts at a large discount broker during
1991 to 1996 and showed no evidence of portfolio inertia, but due to overconfidence, household
turned over 75 percent of its portfolio annually and result in a poor performance. Through
introducing the concept of ambiguity, [20] found the evidence of institutional investor portfolio
inertia under the assumptions of Choquet expected utility.
For the cause of portfolio inertia, [21] found that transaction cost and information one are
important for investors to implement a consistently profitable accruals strategy. If the costs
are too high, investors can profit from adjusting the portfolio. So transaction cost is the main
source of portfolio inertia, but it maybe just make sense for the individual investors. [22] studied
the portfolio choice problem under ambiguity, and proved that portfolio inertia is defined when
there is belief commonality between the optimists and pessimists of the market. Therefore,
the common belief is the main source of portfolio inertia. [23] analyzed investors’ portfolio
selection problems in a two-period dynamic model of Knightian uncertainty. Incorporating
investors updating behavior, they accounted for the existence of portfolio inertia in this two-
period framework: New observation in the first period will lead portfolio inertia in the second
period if the degree of Knightian uncertainty is sufficiently large. So, uncertainty is another
source of portfolio inertia.
In conclusion, the existing literatures ignore to study the way of uncertain information
affecting stock price. From the perspective of the mediation effect, we will first define the
logical relationship of uncertain information, portfolio adjustment and price volatility, and
then explore how earnings surprise affect price volatility by means of portfolio adjustment of
institutional investor.
3 Methodology
3.1 Hyp othesis
Earnings surprise depend largely on the accuracy of the investors’ expectation on the com-
pany’s future earnings. The higher the degree of information ambiguity, the less is the accuracy
of earnings expectation, and the greater is the earnings surprise
[6,24]
. In a mature market, this
accuracy mainly comes from two ways: The first is the relevance of the company’s future earn-
ings and its past public financial information; the second is investors’ forecast ability on the
company’s future earnings. In A-stock market, however, the factors that influence the earnings
surprise are much more complicated, and the phenomenon of incomplete information is much
more serious, such as the immature market, defects of system design, inadequate disclosure
of information of listed companies, and the limited ability of investors to obtain and digest
information, etc. Therefore, it is common to find that the listed company’s actual earnings are
above or below expectations when the company releases the earnings announcement. In this
