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  • Could More Transparent Accounting Increase Expected Mispricing in Equity Markets?

    Experienced equity analysts think so.  At least that is the answer provided by my recent research (with Brooke Elliott from University of Illinois at Urbana-Champaign).  We find that analysts expect more and longer lasting stock mispricing when the effects of certain business transactions are more transparently reported and a firm’s most important investors are transient rather than dedicated institutional shareholders.

    Our study helps link two conflicting streams of research on the effects of increased transparency on expected mispricing.  Researchers from a psychology tradition would tend to expect an increase in transparency to lead to an improvement in judgment, i.e., more accurate pricing in an equity market.  However, researchers from an economics tradition would be less surprised by possible limitations to the benefits of greater transparency, or by the possibility that more transparency can impair market behaviors.  As noted by Nobel Laureate Vernon Smith [1991,p. 881],

    The fact that private information experimental markets converge more quickly and reliably to certain rational predictions than complete information markets do directly contradicts the conclusion of Tversky and Kahneman [1987; p. 88]: "Perhaps the major finding of the present article is that the axioms of rational choice are generally satisfied in transparent conditions and often violated in nontransparent ones." This is correct in their context, but in experimental markets rational theory often performs best in the "nontransparent" (low-information) environment and worst in the "transparent" (high-information) environment. The leap is so great when one goes from data on individual choice behavior to observed behavior in experimental markets that conclusions of this sort are reversed!

    We demonstrate this counter-intuitive finding, relying on the notion of Keynesian beauty contests and higher-order beliefs (i.e., beliefs about what others believe). 

    In such strategic settings, changing the beliefs of a subset of market participants will not necessarily alter prices in the same direction.  For example, some investors may choose to exploit overpricing by buying shares, hoping to close their positions after the mispricing becomes severe, but before the mispricing is corrected.  Greater transparency can exacerbate this effect by increasing other investors' awareness of the potential to implement this "ride the bubble" strategy, thus introducing greater uncertainty about which market participants have employed each of the possible strategies in play, especially if there are few longer-horizon traders present to discipline market prices.

    Traditionally, we naturally tend to think that more transparent accounting will help investors better allocate capital and help equity markets be more efficient.  When we peer into the minds of expert analysts, however, we document that they systematically believe more transparent accounting can sometimes backfire.  More transparency can increase uncertainty regarding which market participants (sophisticated or unsophisticated) might be employing any of the multiple (naïve, arbitraging, or exacerbating) strategies potentially in play. Under such circumstances, sophisticated investors' best response is unclear, and the result is that market price is prevented from immediately converging to fundamental value.

    For more see: 

    ELLIOTT, W., KRISCHE, S. D., & PEECHER, M. E. (2010). Expected Mispricing: The Joint Influence of Accounting Transparency and Investor Base. Journal Of Accounting Research, 48(2), 343-381. doi:10.1111/j.1475-679X.2010.00370.x

    SMITH, V. Rational Choice: The Contrast between Economics and Psychology. Journal of Political Economy 99 (1991): 877-97.

    TVERSKY, A., AND D. KAHNEMAN. "Rational Choice and the Framing of Decisions," in Behavioral Foundations of Economic Theory, edited by R. M. Hogarth and M. W. Reder, Chicago: University of Chicago Press, 1987: 67-94.

     

    _________________________
    Mark Peecher
    Deloitte Professor of Accountancy