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 boost investors’ expectations of the firm’s growth potential and its stock price, but may also cause disproportionally larger price declines if the firm cannot meet investors’ high expectations. In equilibrium, only managers with favorable information use stock splits to signal. Empirical analyses of stock splits in China find supporting 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, along with the unique institutional features of the Chinese market, help differentiate our behavioral explanation from alternative explanations within the rational framework.

What are the benefits to a firm of having investors with gambling preference as shareholders? Motivated by studies showing that gambling investors prefer lottery-like stocks and require lower expected returns to take risk, we hypothesize that firms with positively-skewed assets can use stock splits to attract investors with gambling preference to share risk and to lower cost of equity. Indeed, analyzing a sample of Chinese firms that split their stocks through stock dividends and using proprietary trading data to measure retail investors’ gambling preference, we find that, on average, shareholders increase by 54% and retail gambling investors increase by 119% following stock dividends. Furthermore, while firms become more risk-taking, their cost of equity declines substantially, largely due to the increased retail gambling investors’ pricing influence. Thus, stock splits are effective for improving risk-sharing efficiency, and gambling investors contribute to lowering the cost of capital.