Earnings Optimism Heuristics and Long-Term Stock Returns (Revision 3 )

The authors introduce a simple a cognitive shortcut investors use to assess managerial ability based on theconsistency of segment-level earnings within conglomerates: the Earnings Optimism Heuristic (EOH). They document that EOH amplifies the negative relationship between long-term expected earnings growth (LTG) and future stock returns: high-LTG conglomerates with high EOH experience stronger underperformance, with an annual alpha of -10%. Difference-in-difference analyses show that while SFAS 131 improves analysts’ LTG forecasts, they remain unaffected by EOH. In contrast, mutual funds rely on EOH, increasing their active holdings in high-EOH conglomerates and experience subsequent long-term underperformance.