When the Use of Positive Language Backfires: The Joint Effect of Tone, Readability, and Investor Sophistication on Earnings Judgments

Abstract

Recent studies document that market participants react positively to the positive language sentiment or tone embedded in financial disclosures, and that investors' reactions to negative news are more muted with poor disclosure readability. However, while language sentiment and readability co-occur in practice, their joint effects remain largely unexplored. In an experiment with MBA students as participants, we investigate how the effect of language sentiment varies with readability and investor sophistication level. We find that language sentiment influences investors' judgments when readability is low, but not when readability is high. Specifically, when readability is low, disclosures couched in positive language lead to higher earnings judgments for less sophisticated investors, but lower earnings judgments for more sophisticated investors. These findings show that the main effects of readability and language sentiment documented in prior studies have boundary effects, and may reverse when both variables are jointly considered along with investor sophistication.

Calisthenics with Words: The Effect of Readability and Investor Sophistication on Investors’ Performance Judgment

“…These results are different from the Tan et al [5] study, wherein they find that low readability obscures but does so with low-sophistication investors only, while high readability essentially establishes a baseline of both groups understanding the financial information. There may be several factors in play to explain this.…”

“…There may be several factors in play to explain this. Firstly, the two studies examine different main effects, with Tan et al [5] focusing on the framing effect of positive tone as jointly moderated by investor sophistication and readability, while this study focuses on the main effect of readability on investors of differing …”

“…Financial literacy of participants is measured based on demographic information, according to the method used by Tan et al [5]. Participants are asked about the frequency with which they engage in investing behavior, number of accounting courses they have taken, number of finance courses they have taken, their frequency of reading annual reports, and their frequency of reading earnings releases.…”

“…Early studies ( [1][2][3]) find that readability does have an effect on investors, acting especially upon small investors to limit their willingness or ability to extract information from financial disclosures. By taking an experimental approach, Rennekamp [4] and Tan, Wang and Zhou [5,6] have gone further in studying readability and its influence on investor judgments and investor decision-making, by examining the cognitive influences that readability has on how investors process financial information. There remains, however, a dearth of research on the role that financial literacy might play in simultaneously also influencing investor judgments.…”

Rate or Trade? Identifying Winning Ideas in Open Idea Sourcing

“…For instance, Ghose and Ipeirotis (2011) show that higher readability of user-generated online reviews positively influences purchase decisions. Similarly, Tan et al (2014) found that readability moderates the effect between the presentation of financial reports and the investors' earning evaluations.…”