Behavioral Accounting vs. Behavioral Finance

INTRODUCTION AND OBJECTIVES

An economic theory which is not incorporating human behavior is not imaginable. For reasons of simplification economic models traditionally use the concept of a rational acting market participant. In order to face the inadequateness of this abstraction behavioral economic science reject the assumption of the homo economicus and adds various findings from supporting disciplines as psychology, sociology, and organizational theory. While the exploration of human behavior in finance theory has a long tradition, research in the area of psychological effects in accounting started not earlier than the mid of last century. The main intention of modern financial reporting is the supply of useful information for actual and potential investors within their decision-making process. As information processing of agents on the market for equity is part of finance theory, this is the meeting point of the two disciplines. The intention of this paper is to identify overlapping contents of behavioral research in finance and accounting. For clarification selected studies from Behavioral Finance Research (BFR) and Behavioral Accounting Research (BAR) literature will be presented and comparatively analyzed. In addition varying fields of research of both schools which are not related with each other were outlined.

BEHAVIORAL FINANCE RESEARCH (BFR)

Classic economic theory as developed by economics like ADAM SMITH, DAVID RICARDO and JOHN STUART MILL is based on the idea of the homo economicus.^[1] The homo economicus seeks to receive the highest possible well-being for himself given available information about opportunities and other constraints, on his ability to achieve his predetermined goals.^[2] Homo economicus is seen as "rational" in the sense that well-being as defined by the utility function is optimized given perceived opportunities (with the greatest extent and least possible costs).^[3] Furthermore, the individual is able to process all relevant information in a appropriate manner.

Taking this into finance theory, the market for equity should be predictable and driven by public information and the consequent rational reaction of its agents. But since organized capital markets exist prices seem to be randomly settled and unpredictable. In 1900 LOUIS BACHELIER stated that stock prices reflect reactions to information coming to the market in random fashion, so they are no more predictable than "the walking pattern of a drunken person".^[4] This is known as the "random walk" in finance theory. Also JOHN MAYNARD KEYNES recognized in 1936 that the price on the market reflect the expectations of the future trend; regardless if the expectations are based on wrong or correct assumptions. So the question was raised if the market behaves irrational. The nobel-prize-winning answer was: no! PAUL SAMUELSON (1965) argued that the rationality of the investors is the reason for the fluctuation of the prices on the capital market. Prices on the capital market are the result of the cumulated amount of discounted dividends. Random fluctuation of prices are due to random variances of earnings and their expected trends. Neoclassical theory was established and influenced EUGENE FAMA in 1970 to his Efficient Market Theory (EMT). The bottom line of this theory is that there is perfect information in the stock market. All data are fully and immediately reflected in a stock price. This means that whatever information is available about a stock to one investor is available to all investors. Since everyone has the same information about a stock, the price of a stock should reflect the knowledge and expectations of all investors. No group has access to information that would enable it to earn superior risk-adjusted returns (Arbitrage).

Based on MARKOWITZ`s portfolio theory a rational investor calculates the asset price with the Capital Asset Pricing Model (CAPM), which means that the price is the result of the linear dependence of the expected return and the risk.^[5] Therefore irrational behavior could occur either in processing information regarding the future performance or during the risk assessment. These are the points where Behavioral Finance joins the game. Empirical findings describing biases in behavior of investors regarding their risk assessment led KAHNEMAN/TVERSKY (1979) to their Prospect Theory, which ennobled Behavioral Finance to a systematic and accepted science. Moreover anomalies regarding the information processing of market participants were identified and challenged the EMT. The following event studies show some examples for irrational incorporation of information into stock prices:

Example 1"The Sorry Tale of the Cure for Cancer"

HUBERMAN/REGEV (2001) detected the informational imperfection of markets by showing that even a "non-event" had a major market impact. On Sunday 3 May 1998, the New York Times carried an article on a new cancer drug being researched by EntreMed. EntreMed`s stock price rose from $12 on previous Friday up to $85 at the beginning of the week. The stock subsequently fell back during trading on Monday 4 May to close a very respectable $52. Three weeks later the stock price was still above $30. Now it could be argued that this was the efficient market incorporating of new information. But that was exactly the problem. This wasn`t new information. The potential breakthrough had been reported no less than five month earlier in numerous popular newspapers including the New York Times. Enthusiastic public attention induced a permanent rise in EntreMed`s share price, even though no genuinely new information had been given to the market.

Example 2"Massively Confused Investors Making Conspicuously Ignorant Choices"

RASHES (2001) examines the co-movements of stocks with similar ticker symbols. Ticker symbol confusion is found to lead to interesting price movements in stocks for which there is no new information introduced to the market. MCI Communication (MCIC) is a large telecommunication company in the USA. From the end of 1996 through 1997, it was engaged in merger negotiations with Worldcom. Until the acquisition, it traded on NASDAQ with the ticker MCIC. Massmutual Corporate Investors is a closed end fund that trades on NYSE under the ticker MCI. The fund invests most of its assets in long-term corporate debt and converts. In spite of the fact, that MCI and MCIC have nothing to do with each other, there is an unusual degree of co-movement between the two stocks. Between November 1 1996 and November 24 1997, of the 24 days during which 10,000 or more shares of MCI changed hands, 18 are days on or immediately prior to significant announcements relating to MCIC merger plans. The mistake done by investors is obvious.RASHES goes on to document another five cases in which ticker confusion has caused some bizarre market movements.

Example 3"Dot.coms and Name Changes"

COOPER et. al. (2001) studied firms that changed their names to include some mention of dot.com. Across their sample of firms drawn from AMEX, NYSE and NASDAQ between June 1 1998 and July 31 1999, COOPER et al. find that in the five days surrounding the announcement of a name change to incorporate dot.com into corporate title, an abnormal return of 53% is generated. Even in the + 60 days event window an abnormal return of 23% is generated. But perhaps the most bizarrely finding was that firms whose core business is unrelated to the internet, but who nevertheless decide to amend their name to include a dot.com reference, generate a 23% abnormal return in the five days surrounding the announcement, and even worse a 140% abnormal return in the + 60 event window.

These examples show some biases in behavior of investors during their information processing for stock valuation. Other directions in Behavioral Finance investigate anomalies in finance related behavior in the areas of Asset Allocation, Portfolio Construction and Risk Management, and Corporate Finance (see figure 1).^[6]

Figure 1 Schools of BFR

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JDM = Judgment and Decision Making

BFR in the area of stock valuation deals with the behavior of Investors and Analysts regarding their information processing related to their investment decisions. As showed above biases inconsistence with the EMT, e.g. imperfect information, are investigated. In the field of stock valuation the assumptions of the CAPM are also doubt and experimental and empirical evidences towards the violation of these assumptions exist. Most of the studies deal with the discount factor for the cost of capital in the val]uation process.^[7] As a reaction to these findings FAMA and FRENCH developed the three-factor model (FF3) to improve the CAPM in 1993.

BFR in the field of asset allocation investigates the rational distribution of investments in stocks and bonds. The equity risk premium stands in the focus of this research area.^[8] Furthermore, the well-know bias that initial public offerings (IPOs) or seasoned equity offerings (SEOs) underperform the broader market, is tried to be explained by behavioral approaches in this field.^[9]

Biases in the modern portfolio theory are mostly due to anomalies in the behavior of investors and analysts regarding their risk assessment or in technical terms their estimation of correlation and covariance. As an seminal work DANIEL and TITMAN (1998) showed that a characteristic model performs better in predicting expected returns than the classic covariance model. That finding has important implication for portfolio construction and risk management.

The least explored implications of the behavioral approach are those related to the corporate finance arena.^[10] Nevertheless classic constructs of corporate finance as MODIGLIANI and MILLER`s capital structure and dividend irrelevance theorems are based on the precept of market efficiency.^[11] The most relevant psychological biases in the context of management are over-optimism and over-confidence.^[12]

Table 1 Selected literature ordered by the "schools of BFR"

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^[1] The term economic ma n was introduced in JOHN KELLS INGRAMs "A Hiostory of Political Economy" in 1 888; VILFREDO PARETO used the latin term homo economicus first in 1906 .

^[2] Cf. THALER (2000), p. 134.

^[3] Cf. FRANZ (2004), p. 83.

^[4] BACHELIER (1964), p. 256.

^[5] Cf. SHARPE (1964), LINTNER (1965), MOSSIN (1966).

^[6] The systematization of fields in BFR follows MONTIER (2007).

^[7] Cf. e.g. LINTNER (1965), HORWITZ et. al (2000).

^[8] Cf. BARBERIS et al. (2000), CLAUS/THOMAS (2000), WELCH (1999).

^[9] Cf. NELSON (1999), BAKER/WURGLER (2000), SCHILL (2000).

^[10] Cf. MONTIER (2007), p. 145, and in general see SHEFRIN (2007).

^[11] Conflicting evidences to this theorem were found by e.g. BENARTZI et al. (1997).

^[12] Cf. WEINSTEIN (19 80), DE BONDT/THALER (19 85), COI/ZIEBART (2000), IRANI (2000), HEATON (199 8).