Academic journal article Academy of Accounting and Financial Studies Journal

The Impact of Disclosing Management's Past Forecast Accuracy on Nonprofessional Investors' Heuristic Decision-Making

Academic journal article Academy of Accounting and Financial Studies Journal

The Impact of Disclosing Management's Past Forecast Accuracy on Nonprofessional Investors' Heuristic Decision-Making

Article excerpt

INTRODUCTION

With the dramatic increase in the availability of personal investment websites and the increasing number of individuals choosing to manage their own investment portfolios (Looney et al. 2006), understanding the needs for, and uses of, publicly-available information by nonprofessional investors when making their investment decisions have become more important (Barron et al., 2004). The nonprofessional investor is challenged by the need to predict future earnings, stock returns, and risk (Moser, 1989). In addition, behavioral research in finance and accounting indicates that, because of the inherent uncertainties in the decision-making process, investors often rely on heuristics (rules-of-thumb) when making investment decisions (DeBondt, 1998).

Heuristics are decision rules which develop over time and are stored in memory (Chen et al. 1999). Their use is triggered by the receipt of heuristic cues which are information items related to the decision at hand. Heuristic cues used in investment decisions may include company name recognition (Teoh & Wong, 1993), CEO reputation (Cianci & Kaplan, 2010), and past stock prices (DeBondt, 1998). While heuristic cues such as these can be helpful when making investment decisions, they can also lead to poor choices because they often don't have a direct relationship to the firm's earning potential or investment worthiness (DeBondt, 1998).

The use of heuristics results in investors developing intuitions about their investment decisions (DeBondt, 1998). This first impression (or initial preference), once formed, functions as a decision default (Chaiken et al. 1989). The decision to stay with, or switch away from, the initial preference depends upon the strength of "constraint information" which is information that either contradicts the initial preference or supports an alternate decision (Simmons & Nelson, 2006). Accordingly, as investors obtain additional information about the firms they are considering for investment, their initial preferences may be strengthened or weakened. Unfortunately, some types of constraint information related to investment decisions can be difficult for nonprofessional investors to use because the information may be difficult to interpret and/or access. An example of this type of information is management's earnings forecast.

A well-established literature stream has shown that management's earnings forecasts provide decision-useful information to investors (Waymire, 1984; Pownall & Waymire, 1989). From the individual investor's perspective, management forecasts provide forward-looking information that can be useful when predicting future cash flows. However, the interpretation of earnings forecasts can be difficult because its value is dependent, at least in part, upon the perceived reliability of the forecast. For instance, a reputation for highly accurate forecasting based on past disclosures increases the perceived reliability of subsequent management forecasts (Benjamin & Strawser, 1974; Williams, 1996). While knowing how accurate management has been in the past is helpful, this information is often difficult to acquire because it is not currently a required disclosure. Thus, managements' earnings forecasts potentially represent an important source of constraint information, but the appropriate use of this information may be dependent upon the knowledge and/or experience of the investor.

The present study is an initial exploration into nonprofessional investors' use of management's earnings forecasts. Specifically, we consider the impact of specifically stating management's past forecast accuracy after investors have already established an initial investment preference. The experiment included 102 business students with limited investment experience assuming the role of nonprofessional investors. Each was presented with case materials describing two fictitious firms being considered for investment. …

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