Investor protection and stock performance: theoretical mechanisms and global empirical evidence Open Access

Investor protection, according to La Porta et al. (1998), is a safeguard provided by legal authorities for investors from outside the company, including minority shareholders and creditors, against wealth tunneling activities taken by managers and large shareholders. Generally, finance literature documents the positive impact of investor protection on firms and economies. For example, stronger investor protection leads to more valuable and better developed equity markets (La Porta et al., 1997, 2000; Shleifer and Wolfenzon, 2002). At the firm level, better investor protection appears to have a positive effect on corporate innovation (Hsu et al., 2014), leads to lower riskiness (Ghabri, 2022; Vo and Mazur, 2023). Moreover, the level of investor protection has been found to be positively associated with the quality of the accounting information and the level of dividend payouts (Leuz et al., 2003). While the impact of investor protection on firms and overall economic development has been well-documented, its direct effects on stock performance, particularly stock returns and volatility, remain underexplored.

The existing studies provide mixed evidence. While Giannetti and Koskinen (2010) suggest that stronger protection reduces risk and enhances returns, Albuquerque and Wang (2008) argue that stocks in a high-protection environment have lower volatility but also potentially lower expected returns. These inconsistencies suggest a need to reconsider the mechanisms through which investor protection influences stock outcomes. Moreover, recent studies tend to use aggregate market indicators, such as market index volatility, to proxy risk (Silva et al., 2024), which may obscure firm-level dynamics. This leaves an important gap regarding how investor protection influences firm-specific stock performance, including both return and risk measured by individual stock volatility and idiosyncratic risk. Another underexplored area is the contextual variation in how investor protection affects stock performance. Institutional theory (Meyer and Rowan, 1977; Scott, 1987, 1995; Oliver, 1996) suggests that the effectiveness of governance mechanisms like investor protection may depend on the broader institutional environment (IE). Yet, few empirical studies explicitly test whether the impact of investor protection varies depending on factors such as the rule of law, corruption control or firm transparency (FT). This study seeks to address these gaps by examining the impact of investor protection on firm-level stock returns and volatility across multiple countries. We aim to contribute to a broader understanding of how legal and institutional frameworks shape the relationship by exploring the conditional effects of institutional quality and FT, offering a more context-dependent view of the investor protection–stock performance relationship.

The remainder of the paper is organized as follows. Section 2 reviews the literature and develops hypotheses. The sample and methodology are described in Section 3. The findings are discussed in Section 4, while Section 5 concludes the paper.

Investor protection – defined as the extent to which legal systems shield external investors from expropriation by corporate insiders (La Porta et al., 1998) – is a country-level institutional factor that has wide-reaching implications for firm behavior and financial outcomes. The theoretical foundation for linking investor protection to stock performance lies in agency theory (Alchian and Demsetz, 1972; Jensen and Meckling, 1976), which posits that conflicts of interest between managers and shareholders or between outsiders and insiders give rise to agency costs. Legal systems that strengthen investor rights serve to reduce these agency costs, align incentives and thereby influence firm-level outcomes such as risk-taking, disclosure quality and ultimately stock performance. Many studies document that stronger investor protection is associated with better governance, higher firm valuation, lower private benefits of control and greater access to external finance (La Porta et al., 2000; Shleifer and Wolfenzon, 2002). These studies typically emphasize the disciplining role of legal protection, framing it as a mechanism that enhances efficiency and shareholder value. However, the uniformly beneficial view of investor protection can be questioned, particularly in the context of demand for innovation, strategic risk-taking or investment under uncertainty. From this perspective, strong legal protections may constrain managerial flexibility and prevent behaviors that, while risky, are essential for generating high stock returns.

Investor protection can affect firm-level stock volatility through several channels. In weak legal environment, insiders face fewer constraints and are more likely to engage in opportunistic behaviors such as earnings manipulation, tunneling or withholding bad news (Johnson et al., 2000), thus increasing information asymmetry and uncertainty. In contrast, strong investor protection can improve disclosure, which helps lower information asymmetry between managers and outside investors (Zhang et al., 2017). Empirical studies support this logic. For example, Jain (2003) finds that shareholder rights are associated with narrower bid-ask spreads, while Brockman and Chung (2003) and Silva et al. (2024) document a negative association between legal protection and stock return volatility across countries. These findings suggest that investor protection enhances market confidence, thereby reducing firm-level stock price fluctuations.

Investor protection may also influence firm-level stock returns although the theoretical direction is less straightforward. On one hand, stronger protection reduces expropriation risk and increases investor confidence (Giannetti and Koskinen, 2010; Johnson et al., 2000), which may enhance expected returns through increased demand and capital inflows. From this perspective, investor protection facilitates better governance, lower risk of crash events and more efficient capital allocation, leading to higher stock returns (Zhang et al., 2017).

On the other hand, a contrasting line of theory suggests that stronger investor protection may lead to lower stock returns, especially if protection lowers risk exposure and enhances liquidity. According to Amihud and Mendelson (1986) and Amihud (2002), less liquid assets command a premium; thus, if legal protections increase stock liquidity, the stock returns may decline. Furthermore, Albuquerque and Wang (2008) argue that investors in markets with poor investor protection may command higher risk premiums on stocks due to the elevated uncertainty and weak enforcement mechanisms. This alternative view implies that higher investor protection may lead to lower stock returns.

La Porta et al. (2000) suggest that the effectiveness of investor protection is highly context-dependent on the IE of a country. In nations with weak IE (e.g. poor rule of law and high corruption), investors tend to respond strongly to even a modest enhancement in investor protection (Klapper and Love, 2004). Institutional theory (see Meyer and Rowan, 1977; Scott, 1987, 1995; Oliver, 1996) suggests that formal rules are only part of the picture, and enforcement quality and supporting governance structures are essential for laws to shape behavior.

In countries with weak institutions, investor protection laws may play a critical role in offsetting broader governance deficits. In contrast, in high-quality IE, the marginal benefit of investor protection may be diminished because broader legal and regulatory systems already constrain managerial misconduct (Klapper and Love, 2004). Therefore, we expect that the relationship between investor protection and firm-level stock outcomes is weaker in countries with strong IE.

While investor protection is primarily established at the country level, firms also differ in their internal governance and transparency practices. According to agency theory, firm-level mechanisms such as audit quality, analyst coverage and disclosure transparency can mitigate information asymmetry and reduce the need for external legal protections (Doidge et al., 2004; Haidar, 2009). When firms provide reliable financial information and are subject to regular monitoring by external analysts or auditors, the marginal value of investor protection may decline, particularly for investors concerned about insider opportunism.

From this perspective, firms with greater transparency already exhibit reduced agency conflicts, which may substitute for weak investor protections in the external environment (Klapper and Love, 2004). As a result, we expect the relationship between investor protection and stock performance to be less pronounced for firms with strong internal transparency mechanisms.

The full sample period spans from 2010 to 2019 ^[1] for 39 countries (the list of countries is provided in Table 1 of the Supplementary document). After removing countries with less than 10 firms and firms with cross-listing, we come up with 169,501 firm-year observations. Data for investor protection are from the Spamann (2010) corrected ADRI. Firm-specific variables are calculated based on Datastream, Compustat Global and Worldscope. All firm-level variables are winsorized 0.5% in each tail in order to avoid the problem of outliers.

The source for collecting macro-characteristics is World Development Indicators. Control of Corruption is taken from the studies of Djankov et al. (2003) and Rule of Law is from the World Bank database.

The baseline model is defined by

where ADRI_j is the Antidirector Right Index of country j, which is a proxy for investor protection. This index rates the degree of legal protection offered to minority shareholders from insiders’ expropriation. ADRI is supposed to be appropriate for a global sample with a high concentration of controlling shareholders. In the regressions, a set of firm-specific characteristics (Firm_Controls) that might affect stock performance is controlled. Following Ferreira and Matos (2008), Chen et al. (2013), Dang et al. (2018), and Vo et al. (2022), we include natural logarithm of the market value of equity (MV), return on assets (ROA), market-to-book ratio (MB), fraction of shares held by insiders and controlling shareholders (CH), Amihud’s (2002) illiquidity (LIQUID) and the natural logarithm of stock price at the end of the year (PRICE). In addition, some country’s macroeconomic variables (Macro) are added, including the GDP growth (GDP), market capitalization of all stocks listed on the stock exchange to GDP (MCAP) and the amount of private credit to GDP (PCREDIT).

$Stock_Performanceijt$ is stock performance of stock i in country j in year t. Stock performance variables include stock volatility and stock returns. Following Sias (1996) and Chen et al. (2013), the annualized standard deviation of weekly stock returns (STD) is used as a measure of stock return volatility. Furthermore, following Ferreira and Laux (2007), the idiosyncratic risk (IVOL) is employed, which is defined as the annualized standard deviation of the residual (ε) estimated from Eq. (2).

where $StockReturni,j,t$ is stock return of stock i in country j at time t and Market Return_j,t is the average of weekly stock return of firms in country j at time t.

To explore the role of FT and IE in the relation between investor protection and stock performance, the two following models are run:

And

Firms’ information transparency (FT) is measured in three ways: the natural logarithm of one plus the number of financial analysts following a firm (ANALYST), quality of auditing (BIG4) and earnings management (EM). Note that while ANALYST and BIG4 directly measure the corporate information transparency, EM is a proxy of information opaqueness.

To control for country-level IE, Control of corruption as in Djankov et al. (2003), Rule of law (Kaufmann et al., 2011) and Creditor rights index (the revised creditor right index as in Djankov et al. (2007)) are used.

All regressions control for the country-, industry- and year-fixed effects and are estimated using robust standard errors clustered at the firm level to account for heteroscedasticity.

To save space, we present the tables of Summary statistics and Correlation matrix in the Supplementary document (i.e. Tables 2 and 3, Supplementary document). The average volatility (STD) is 44%, idiosyncratic risk (IVOL) has a mean of 40% and the average stock return is 8% (RETURN). The typical firm size is 21.44 (in logs), which translates to over $2 billion. Further, accounting performance measured by ROA is 0.02 and the average Market-to-Book is 2.09. The investor protection level (ADRI) has a mean value of 4.08 and a maximum value of 6, whereas Rule of law and Control of corruption are 0.85 and 2.08 at the mean, respectively.

ADRI is negatively correlated with both volatility measures (STD and IVOL) and positively correlated with the stock return with the p-value <0.01. ADRI is also positively related to MV but negatively associated with ROA.

As shown in Table 1, Columns 1–4, investor protection is inversely correlated with stock return volatility, measured as either STD or IVOL. More specifically, for STD models, the coefficient estimates on ADRI are −0.046 without controlling for the macroeconomic variables and −0.049 with all controls included in the model. When regressing IVOL on ADRI, the coefficient estimates are −0.038 and −0.040, respectively, that are also highly statistically significant. Thus, overall, it seems that investor protection has a diminishing effect on stock return volatility. The inverse relationship between the level of investor protection and stock return volatility indicates that in countries with strong investor protection, equity markets are significantly more stable (less volatile) and outside investors are exposed to lower expropriation risks.

These findings are supportive of the hypothesis H1a and consistent with prior studies, including Zhang et al. (2017), Jain (2003), Brockman and Chung (2003), etc which state that expropriation becomes more expensive thanks to sufficient investor protection. With the existence of such legal protection, the agency conflict reduces since it becomes more difficult for managers and controlling stockholders to tunnel the firm assets for their own interests. Besides, firms are required to disclose more accounting information, which helps lower information asymmetry between managers and outside investors.

Columns 5–6 in Table 1 show that for the models with RETURN as a dependent variable, ADRI is negatively associated with stock returns with coefficient estimates that are in the range of −0.059 (p-value <0.01) and −0.096 (p-value <0.01). This result implies that stock returns in countries with strong investor protection are significantly lower compared to stock returns in countries with weak investor protection. These findings are not in line with the hypothesis H1b but support the H1c. We expect that higher investor protection results in lower agency problems and lower risk as a consequence but might also diminish expected returns as a trade-off. The findings are in line with the study of Low et al. (2011), which finds that markets with an inadequate investor protection laws have greater stock returns than markets with greater governance quality. The findings also support Albuquerque and Wang (2008), who demonstrate that inadequate investor protection level encourages higher investment, which in turn raises risk premiums, increases stock price volatility and then raises the expected return rate.

Next, to mitigate endogeneity issues like omitted variable bias and reverse causality, we re-estimate Eq. (1) with the method of system generalized method of moments (system-GMM). The results, as shown in Table 2, are consistent with the baseline findings and again confirm that a higher level of investor protection leads to lower stock returns and stock risk. We also report the p-values of the Arellano–Bond tests for the first- and second-order autocorrelation (AR1 and AR2, correspondingly) and the Hansen test for the validity of the instrumental variables. As can be seen, the application of the system-GMM regression does not encounter any issues related to autocorrelation or invalid instruments.

As an additional test, we present the regression results in the COVID-19 time (2020–2021) in Table 4 of the Supplementary document. Basically, the results are still in line with previous findings.

Finance theory predicts that the IE drives corporate behavior and performance (La Porta et al., 1997, 1998). This section investigates the extent to which the relationship between investor protection and stock performance differs across firm-level and country-level institutions.

Klapper and Love (2004) argue that investors in nations with poor legal systems tend to respond strongly to even a modest enhancement in investor protection. To gain insights into the role of IE on the relationship of investor protection and stock performance, the baseline regressions adding the interaction terms IE*ADRI are rerun, where IE stands for popular proxies of the quality of IE including Control of corruption, Rule of law and Creditor right index. Columns 1–6 of Table 3 show that the estimated coefficients on all interaction terms are significantly positive, which supports the moderating role of the IE on the negative link between investor protection and stock return volatility.

The paper next examines the role of IE quality on the link between investor protection and stock returns. As shown in 7–9 of Table 3, the positive coefficient estimates on ADRI*IE are highly significant with p-values lower than 0.01, confirming the moderating role of IE on the negative association between investor protection and stock returns. Altogether, these results support the hypothesis H2, implying that in countries with strong IE, the effect of investor protection on stock performance is less pronounced.

Next, the potential role of corporate transparency on the documented association between investor protection and stock performance is tested. To this end, an interaction term FT*ADRI is constructed, where FT stands for FT variables including BIG4, ANALYST and EM. Columns 1–6 of Table 4 show that the estimated coefficients on the interaction terms between FT variables and investor protection are positive (FT is measured by BIG4, ANALYST)/negative (FT is measured by EM) and statistically significant, which confirms the moderating role of investor protection on the negative association between FT and stock return volatility.

Further, the study examines the role of FT in the association between investor protection and stock returns. As reported in Columns 7–9 of Table 4, the coefficient estimates on FT are positive and highly significant when BIG4 and ANALYST are employed, confirming that corporate transparency can enhance stock returns. Besides, the estimated coefficients on the interaction terms between FT variables (BIG4, ANALYST) and investor protection are significantly negative, implying that the investor protection can substitute for the role of corporate transparency on stock returns. The result with EM is insignificant. Overall, these results are supportive of the hypothesis H3.

These findings imply that the stock performance of more transparent organizations and in countries with strong IE is less affected by the overall quality of investor protection. These results are explained by the fact that investor protection is just one facet of corporate governance, according to Haidar (2009). The board structure, audit quality, compensation scheme are additional corporate governance instruments supporting shareholder rights. Minority investor rights protection can be enhanced through corporate information transparency and a strong IE, which results in stronger stock performance and sustainable firm growth.

Using an international sample of publicly listed firms from 39 countries between 2010 and 2019, the study finds evidence that investor protection decreases stock return fluctuations. Moreover, investor protection correlates negatively with stock returns. The outcomes imply that stocks in well-protected environment have lower risk but might also diminish expected returns as a trade-off. This suggests that investors should consider the quality of investor protection when making investment decisions. In countries with strong investor protection, the reduced agency problems may lead to lower stock risks, but investors should be aware that this could come at the cost of diminished returns.

This study contributes to financial theory by revisiting and refining agency theory (Jensen and Meckling, 1976) in the context of cross-country variation in legal protection. The agency theory suggests that stronger investor protection reduces agency costs, aligns interests and thus improves firm outcomes. However, we argue that this alignment may also reduce risk-taking incentives, leading to lower return volatility and, potentially, lower expected returns. This introduces a trade-off to the agency framework that is often overlooked: while investor protection curbs the exploitation behavior of managers and large shareholders, it may also constrain firm innovation and risk-taking, which are key drivers of returns.

Moreover, this study introduces a contextualized theoretical perspective by arguing that the impact of investor protection on stock performance is conditional on the broader institutional and information environment in which firms operate. While prior literature assumes a uniform relationship between investor protection and firm outcomes, we propose that these effects vary systematically depending on country-level institutional quality (e.g. rule of law, corruption control and creditor rights) and firm-level transparency (e.g. analyst coverage and audit quality). This expands the institutional theory (see Meyer and Rowan, 1977; Scott, 1987, 1995; Oliver, 1996), which emphasizes that the effectiveness of governance mechanisms is embedded in broader formal and informal institutional structures. In this way, we contribute to existing studies in the field by showing that investor protection interacts with context rather than exerting a uniform influence. From a theoretical standpoint, our inclusion of moderating variables is not merely exploratory but grounded in the idea that investor protection may be substituted or reinforced by institutional factors. In particular, in countries with strong rule of law, investor protection may be redundant, while in weaker legal environment, its marginal impact may be greater. Likewise, transparent firms may not rely as heavily on investor protection mechanisms because information asymmetry is already reduced.

The findings that the impact of investor protection is context-dependent and varies based on the quality of the corporate information environment have some implications. First, investors should prioritize companies with high levels of transparency, as these firms tend to offer lower risk and potentially higher returns, even in weaker investor protection environment. A focus on firms that emphasize openness in their financial reporting and corporate governance can be a wise strategy, particularly for investors in markets with less robust legal protection. Second, for governments, they can enhance the investment climate by improving investor protection and strengthening institutional frameworks. Strengthening legal protections for investors, reducing the potential for agency problems, and fostering greater corporate transparency can improve overall market efficiency. Governments in countries where investor protection is insufficient may focus on implementing reforms that encourage corporate transparency and better governance practices, which, as the study shows, can offset some of the risks associated with weaker investor protections. Besides, a stronger alignment between corporate behavior and national regulatory standards can improve investor confidence and promote more sustainable market growth.

Future research could extend our study by further exploring the trade-off between risk and returns in different market settings. Additionally, our paper does not consider the role of specific corporate governance mechanisms. Factors such as board composition, executive compensation and executive experience may significantly shape the relationship between investor protection and stock performance.

The supplementary material for this article can be found online.