Do investors like bankruptcies?

They simply weren’t paying enough attention to the right financial clues.

When investing, we generally expect low returns from low-risk stocks and high returns from high-risk stocks. Investors concerned about safety put their money into low-risk companies. Other investors prefer the high-risk ones, where they may win big, or lose big.

But in 1998, financial researchers noticed an anomaly. Companies at higher risk of bankruptcy sometimes attracted more investors and gave lower average returns than financial theory or common sense would suggest. Investors seemed to like these high-risk, low-return firms. This backward relationship puzzled the researchers.

Assistant professor Sohyung Kim decided to investigate this puzzle. He examined the stock returns and bankruptcy risks of 8616 American firms between 1978 and 2007.

Kim first found that the backward relationship only existed for certain investment approaches. People who estimated the chance of bankruptcy one way tended to over-invest in risky firms. People who estimated that chance in other ways did not.

Further investigation uncovered a reason for this. The over-investors paid too much attention to the costs and revenues shown on corporate income statements. They paid too little attention to corporations’ actual cash flows. This was a problem, because running out of cash can trigger bankruptcy even in otherwise healthy firms.

Thus Kim’s study showed that the high-risk, low-return mystery wasn’t due to investors liking bankruptcy. It wasn’t even due to them ignoring that risk. They simply weren’t paying enough attention to the right financial clues. The message here is that investors need to do their financial homework carefully

Sohyung Kim is an assistant professor of accounting. He is interested in the empirical capital market research in accounting and he currently teaches financial accounting at the undergraduate as well as graduate level. He is the 2014 recipient of the Untenured Researcher of the Year Award recognizing research excellence among untenured faculty in the Goodman School of Business.

Kim, S. (2013). What is behind the magic of O-Score? An alternative interpretation of Dichev’s (1998) bankruptcy risk anomaly. Review of Accounting Studies, 18 (2), 291–323.