Individualistic cultures and crash risk

Date01 June 2019
AuthorTung Lam Dang,Lily Nguyen,Hoang Luong,Robert Faff
DOIhttp://doi.org/10.1111/eufm.12180
Published date01 June 2019
D
622 © 2018 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/eufm Eur Financ Manag. 2019;25:622–654.
DOI: 10.1111/eufm.12180
ORIGINAL ARTICLE
Individualistic cultures and crash risk
Tung Lam Dang
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Robert Faff
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Hoang Luong
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Lily Nguyen
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1
Department of Banking and Finance,
School of Economics, University of
Danang, Danang, Vietnam
Email: dangtlam@due.edu.vn
2
UQ Business School, University of
Queensland, St Lucia, QLD 4072,
Australia
Email: r.faff@business.uq.edu.au
3
School of Economics, Finance, and
Marketing, RMIT, Melbourne, VIC 3000,
Australia
Email: hoang.luong@rmit.edu.au
4
Department of Economics and Finance,
La Trobe University, Melbourne, VIC
3086, Australia
Email: lily.nguyen@latrobe.edu.au
Abstract
This study examines whether individualistic national
culture is associated with stock price crash risk (crash
risk) for a sample of firms from 36 countries over the period
of 19902015. We find robust evidence that firms in more
individualistic cultural settings exhibit higher future crash
risk. Digging deeper, we find that earnings management,
excessive managerial risk-taking, and investorsdifference
of opinion and overconfidence are all possible explanations
for the positive effect of individualism on crash risk.
Overall, our findings suggest that individualism, as a key
cultural dimension, has an important impact on investor
welfare, manifested through crash risk.
KEYWORDS
earnings management, excessive managerial risk-taking, individualism,
national culture, stock price crash risk
JEL CLASSIFICATION
G12, G15
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INTRODUCTION
Stock price crash risk (hereafter crash risk) refers to the likelihood of a sudden, drastic decline in stock
price (see, e.g., Hong & Stein, 2003; Jin & Myers, 2006) and captures asymmetry in risk attributes,
which is important for investment decisions and risk management. In this study, we examine whether
We are grateful to John A. Doukas (the editor) and an anonymous referee for constructive comments and suggestions that
have helped improve our paper significantly. We appreciate helpful comments from the participants at the La Trobe
University seminar, Vietnam International Conference in Finance 2016, and the 2017 Finance and Corporate Governance
Conference at the University of Wellington, New Zealand. All errors remain our own.
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the individualistic dimension of national culture is associated with stock price crash risk. According to
Hofstede (1980), culture is the collective programming of the mind that distinguishes members of one
group or category of people from other groups. Adopting this perspective, culture forms the lens
through which people see the world, as well as shaping their perceptions, inferences, and judgments of
the self, others, and their environments (Markus & Kitayama, 1991; Oyserman & Lee, 2008), all of
which affect their decision-making (North, 1990; Williamson, 2000). Although prior literature (e.g.,
Chui, Kwok, & Zhou, 2016; Eun, Wang, & Xiao, 2015; Griffin, Guedhami, Kwok, Li, & Shao, 2017;
Lavezzolo, Rodríguez-Lluesma, & Elvira, 2018; Li, Griffin, Yue, & Zhao, 2013; Shao, Kwok, &
Zhang, 2013) has shown the importance of culture in the decision-making of both firm managers and
investors, whether and to what extent culture affects crash risk remains largely unanswered. Using the
most dominant dimension of Hofstede's (1980) measures of national culture, namely, individualism,
we offer new insights into this knowledge void.
According to Hofstede (1980), individualism is a preference for a loosely knit social framework in
which individuals are expected to take care of only themselves and their immediate families. In
individualistic cultures, the individual forms the basic functional unit, and selfis based on one's
personal rather than group identity; hence, personal autonomy, independence, self-fulfillment, and
personal accomplishments are prioritized over group harmony (e.g., Hofstede, 1980; Oyserman, Coon,
& Kemmelmeier, 2002; Triandis, 2001). We focus on individualism because it is a key proxy used in
cross-cultural studies (e.g., Shao et al., 2013; Triandis, 2001). Importantly, prior research has shown
that individualism affects stock price behavior such as stock price momentum and stock price
synchronicity (e.g., Chui, Titman, & Wei, 2010; Eun et al., 2015). Thus, understanding the effect of
individualism on a sudden, drastic decline in stock price (i.e., crash risk) is important because it
demonstrates whether culture has a real impact on investor welfare, and, flowing into the broader
context, on the stability of financial markets and the economy.
There are at least two strong arguments for why individualism should affect crash risk. The first
argument is based on a burgeoning stream of the literature that attributes the source of crash risk to the
bad-news hoarding behavior of managers (e.g., Andreou, Louca, & Petrou, 2017; Ben-Nasr &
Ghouma, 2018; DeFond, Mingyi, Siqi, & Yinghua, 2015; Jin & Myers, 2006; Kim, Li, & Zhang,
2011a; Xu, Li, Yuan, & Chan, 2014). Driven by incentives such as career concerns or compensation
contracts, managers tend to withhold bad news (Kothari, Shu, & Wysocki, 2009), but when bad news is
accumulated beyond some triggering threshold, it will be revealed all at once, causing stock price
crashes (Jin & Myers, 2006). We assume that managers from individualistic societies possess their
signature cultural traits, such as placing emphasis on personal autonomy, independence, self-
fulfillment, and personal achievements (e.g., Hofstede, 1980; Oyserman et al., 2002; Triandis, 2001),
and overconfidence (e.g., thinking that they are above average) (Chui et al., 2010; Kagitcibasi, 1997;
Markus & Kitayama, 1991). Moreover, we argue that such individualistic cultural traits will likely
induce these managers (compared to those from collectivist societies) to undertake corporate activities
that exacerbate their bad-news hoarding behavior, which can lead to higher crash risk. Based on the
empirical and theoretical literature, we discuss below the two such most relevant corporate activities
(e.g., channels): earnings management and excessive managerial risk-taking.
First, empirical literature (e.g., Chen, Kim, & Yao, 2017; Hutton, Marcus, & Tehranian, 2009; Zhu,
2016) has shown that earnings management is associated with crash risk because it induces significant
negative stock market responses (e.g., Dechow, Sloan, & Sweeney, 1996). In this regard, individualism
can encourage managers to manipulate earnings, which can lead to higher crash risk. Gray (1988) and
Doupnik and Tsakumis (2004) propose a theoretical framework in which a country's choice of
accounting practices can be influenced by its culture. They predict that where individualism is the
dominant culture, accountants and managers have the most flexibility in terms of self-governance and
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measurement and are more likely to report the most optimistic numbers during current or future
periods. In this framework, earnings management is thus more likely to be prevalent in an
individualistic society. Indeed, Han, Kang, Salter, and Yoo (2010) find supporting evidence that
earnings management increases in individualistic cultures. Other studies, by focusing on
overconfidence as one attribute of individualism, find that managers with that attribute tend to
delay loss recognition (Ahmed & Duellman, 2013), have more earnings misstatements (Schrand &
Zechman, 2012), and issue overly optimistic earnings forecasts (Hribar & Yang, 2016). Along these
lines, we argue that possessing individualistic cultural traits such as greater personal autonomy,
discretion, an emphasis on personal achievements and self-fulfillment, and overconfidence, managers
from individualistic cultures may exacerbate their bad-news hoarding behavior by engaging in more
earnings management, leading to higher crash risk.
Second, individualism can encourage managers to engage in excessive risk-taking, which can
exacerbate their bad-news hoarding behavior, thereby leading to higher future crash risk. Since
corporate managers from individualistic cultures have greater personal autonomy in their decision-
making and put a strong weight on their personal achievements and self-fulfillments (e.g., Hofstede,
1980; Oyserman et al., 2002; Triandis, 2001), they are more likely to undertake risky investment
projects due to the higher potential expected payoffs from such projects (Li et al., 2013; Shao et al.,
2013). Importantly, these individualistic cultural traits can induce them to overinvest in these risky
investments. According to the prospect theory of individual risk-taking behavior (e.g., Kahneman &
Tversky, 1979; Tversky & Kahneman, 1991), performance below some reference point can create loss
frames and intensify risk-seeking behavior, while aspirations, expectations, norms, and social
comparisons can shape the reference point (Holmes, Philip, Cynthia, Tim, & Jean, 2011; Tversky &
Kahneman, 1991). Accordingly, we argue that managers from individualistic cultures can engage in
excessive risk-taking if they believe that their firms underperform relative to some reference point such
as their peer firms, or compared to their own firmspast performance, or with reference to some high
level of target performance set by themselves for their own personal achievements and self-fulfillment.
Amplifying the above line of argument, managers from individualistic cultures are generally
(more) overconfident (Chui et al., 2010; Kagitcibasi, 1997; Markus & Kitayama, 1991). Therefore,
they tend to overinvest in risky investments because they are so confident that such investments will
eventually be successful. This excessive risk-taking behavior can be exacerbated by their
overconfidence and self-attribution bias, such that they underestimate the high probability of
downside risk and overestimate the small probability of upside potential of these risky investments.
This argument is consistent with the prospect theory of Kahneman and Tversky (1979) and Tversky
and Kahneman (1991) that risk-seeking preferences for taking on gambles occur when people
underweight most probabilities, particularly large ones, and overweight probabilities near zero
(Holmes et al., 2011). Further, as managers from individualistic cultures are also more independent,
they tend to prefer to do things their own way and be inclined to ignore or explain away privately
observed negative feedback from others for their risky investments. Taking all these arguments
together, we argue that driven by their individualistic cultural traits, managers from individualistic
cultures engage in excessive risk-taking activities, which exacerbates their bad-news hoarding, thereby
leading to higher future crash risk.
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Kim et al. (2016) argue that overconfident managers tend to overestimate the returns to, and their own ability to control
the outcomes of, investment projects that they undertake, as well as ignoring or explaining away privately observed
negative feedback on such projects and engaging in corporate risk-taking. If they misperceive ongoing negative-NPV (net
present value) projects as value-creating and continue with these projects over an extended period of time, the poor
performance of these projects will accumulate and, beyond a tipping point, will lead to stock price crashes.
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