Investing Following Bad News: Worse Is Better

This article demonstrates four principal results. First, returns from an investing strategy based on prior news are driven by future news that reinforces the prior news. This result provides additional nuance to the literature showing that momentum returns occur due to underreaction to news. Second, returns are higher, on average, for firms with bad news in the prior period than for firms with no news in the prior period. While markets initially under-adjust to bad news, there is an increased expectation that there will be bad news in the next period (albeit not high enough), so that negative news in the next period is less costly, positive news in the next period is more profitable, and no news in the next period is akin to good news. Third, returns for firms with two prior periods of bad news or with more thorough bad news are higher than for other firms with bad news. The rationale is that repeated bad news or more thorough bad news convinces investors that the bad news is “real” and results in the market more fully pricing the bad news. Fourth, the market’s response to a given period’s news is a function of prior periods’ news.