An Examination of the Effects of Investor Sophistication on the Pricing of Accruals and Cash Flows

Abstract

We examine the role of sophisticated investors in the pricing of both accruals and cash flows (i.e., the naive-investor hypothesis). Unlike prior research, however, we analyze the returns to three specific trading strategies: 1) returns that are specific to a cash-flows trading strategy; 2) returns that are specific to an accruals trading strategy; and 3) returns that are common to both an accruals and a cash-flows trading strategy. We find evidence consistent with predictions of the naive-investor hypothesis with respect to cash flow mispricing. That is, for returns that are specific to a cash-flows trading strategy, we find that relative to naive investors, sophisticated investors are associated with a significant reduction in the mispricing of cash flows. Consistent with Desai et al. (2004), we find no evidence of mispricing related to accruals. That is, for returns that are specific to an accruals trading strategy, we find no evidence of mispricing for either naive or sophisticated investors. Finally, with respect to returns that are common to both the accruals and cash-flows trading strategies, we find evidence consistent with predictions of the naive-investor hypothesis. That is, significant mispricing exists for naive investors, while sophisticated investors are associated with a significant reduction in this mispricing. In general, our results highlight the importance of considering the common returns to hedge trading strategies when examining the effects of external factors on the pricing of accruals and cash flows.