Investor Culture and Risk Disclosure
Risk assessment is one of the main drivers of capital allocation in financial markets. As investors grapple with the measurement and pricing of risk across securities, a longstanding point of contention for issuers, investors, and regulators is how much corporations should disclose about their exposure to risk in public filings. Too little can leave investors in the dark. Too much can lead to overestimate how risky the firm is as an investment. Hence, firms must strike a balance, so investors do not excessively discount their shares. But what happens when investors in the same stock have different expectations about how much the company should talk about risk? With Heather Li from Bentley University and Patricia Naranjo from Rice University, we examine this question from the viewpoint of culture in our paper titled “Investor Culture and Corporate Disclosure”.
Cross-cultural psychology research has identified dimensions along which individuals differ in their attitudes towards risk and uncertainty. Specifically, Geert Hofstede’s well-known cultural dimensions include uncertainty avoidance (UAD), which captures the amount of tolerance that societies have towards uncertainties. Among the most uncertainty averse countries are Southern European ones like Greece and Portugal and Latin American ones like Uruguay and Argentina. In contrast, the most uncertainty tolerant countries include Southeast Asian ones like Singapore and Malaysia, Northern European countries like Sweden and Denmark, and Anglo-Saxon ones like the U.K. and the U.S. Interestingly, prior research suggests that the cultural uncertainty avoidance of capital market participants affect their investment decisions. The novelty of our research is twofold. First, we test whether culture affects how firms communicate with investors. Second, we test whether the cultural diversity of investors and their conflicting demands for information creates frictions in the stock market.
To examine our research questions, we download corporate annual reports in English for companies across over 40 countries and use risk- and uncertainty-related dictionaries from prior research to compute the amount of risk-related disclosure in each document. We use companies’ headquarters location to infer their cultural uncertainty avoidance. Likewise, we derive the cultural uncertainty avoidance of each institution holding a company’s stock based on its country of origin, as recorded in FactSet. We then average the uncertainty avoidance across all investors, weighted by the number of shares held, to obtain the overall cultural uncertainty avoidance of the investor base.
Regarding our first question, we find that the cultural uncertainty avoidance of both the firm and its investor base are associated with the amount of risk disclosure in the firm’s annual report. That is, the more uncertainty avoidant the firm and its investor base are, the more risk-related words and sentences there are in the annual report. The effect of the investor base is about two-thirds that of the firm, suggesting that foreign investors’ culture matters a great deal in shaping firms’ risk disclosures. To support a causal interpretation of our evidence, we use firms’ addition to the MSCI All-Country Index, which mechanically results in an increase in foreign institutional ownership but is unrelated to the firm’s culture and risk disclosure. We find that firms added to the index change their risk disclosures in a way that reflects the cultural makeup of their investor base. To further address concerns that our results are driven by other country-level differences that are correlated with culture uncertainty avoidance, we re-run our analysis using only U.S. data. Following prior research, we infer the culture of the investor base using the last names of mutual fund managers and their ancestors’ country of origin based on U.S. Census immigration records. Hence, for example, a mutual fund manager with the last name Brochet would be considered as having France’s cultural uncertainty avoidance, even if (s)he is American several generations over. Our results continue to hold in this setting. That is, even U.S.-based mutual fund managers’ cultural roots appear to affect how U.S. firms communicate about risk.
Regarding our second question, we find that firms changing their risk disclosures in response to changes in the cultural uncertainty avoidance of their investor base experience a drop in liquidity. Why would that be? The most likely explanation for our findings is that (some) investors become confused about the increased or reduced risk-related disclosures. Does that mean the firm is taking on more or less risk? We check and find no relation between investor-base uncertainty avoidance and firm risk-taking. Thus, it appears that firms stay the course in how they manage their business, but they change the messaging around it to match investors’ preferences.
The practical implication of our findings is that corporations should be careful in addressing a culturally diverse investor base. While it may be possible to please everyone, corporate managers should mitigate any perception of selective disclosure, an issue that has come up in our conversations with investor relations officers from global corporations. Another more fundamental takeaway from our analysis is that risk disclosures vary meaningfully across countries and matter for stock liquidity and, ultimately, cost of capital. Indeed, ours if the first study to measure risk disclosures in a cross-country setting and link them to capital market outcomes. In the absence of a uniform global regulatory environment for those disclosures, investors should acquaint themselves with how local customs and culture affect annual report narratives related to risk.