A Behavioral Signaling Explanation for Stock Splits

ABSTRACT We propose a behavioral signaling framework to explain the positive announcement effects of stock splits. (Retail) investors view stock splits as good news and are loss averse. Thus, a stock split can raise investors’ expectations of the firm's growth potential and stock price but may also cause disproportionately larger price declines if the firm cannot meet investors’ elevated expectations. In equilibrium, only managers with favorable information use stock splits to signal. Descriptive analyses of stock splits in China provide supportive evidence for this explanation: (1) Investors become more optimistic after stock splits; (2) higher split ratios are associated with stronger market reactions; (3) splitting firms have better future performance than non‐splitting firms; and (4) they experience larger price declines when falling short of investors’ expectations. These findings, combined with the unique institutional features of the Chinese market, help differentiate our behavioral explanation from alternative explanations within the rational framework.