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Abstract:
Two experiments with MBA-student participants support Barberis, Shleifer, and Vishny's (1998) prediction that investors expect random-walk sequences to shift between continuation regimes (in which changes tend to be followed by like changes) and reversal regimes (in which changes tend to be followed by reversing changes). As predicted, investors overreacted to changes that were preceded by many continuations, and underreacted to changes that were preceded by many reversals. We conclude that regime-shifting models can provide a useful framework for understanding market anomalies, including underreactions to earnings changes and overreactions to long-term earnings trends.

Behavioral Finance, Regime Shifting, Post-Earnings-Announcement Drift, Momentum, Market Efficiency

Abstract:
SEC Chairman Arthur Levitt recently called on investors to discourage firms' earnings management by expecting reliable reporting and punishing deceptive reporters (Levitt 1998a, 1999). This paper presents a game-theoretic model in which such punishments can induce managers to develop reputations for reliable reporting. Our first experiment confirms that investors can induce managers to report reliably when one investor visibly commits to a strategy of expecting reliable reporting and punishing reporters who fail to meet that expectation. However, our second experiment shows that reliable reporting is much more difficult to sustain without such a visibly committed investor. These results suggest that managers and investors may have difficulty avoiding the pareto-dominated equilibrium in which managers exploit all of the discretion permitted by GAAP.

Abstract:
In this study, we examine how analysts are affected by the public actions of investors and other analysts by closely examining how analysts revise their earnings forecasts after an earnings announcement. In particular, we hypothesize that analysts observe the actions of investors and other analysts in order to more accurately forecast earnings and have the expertise to determine when these actions are most informative about future earnings. Consistent with our hypotheses, we find that analysts revise their earnings forecasts more strongly in response to returns and other analysts' revisions when these signals are more informative about future earnings changes. We also find that, consistent with analysts being conservative while facing uncertain information, underreactions are strongest (not weakest) when analysts are responding most strongly to these signals (i.e., when the signals are most informative). Lastly, we find that analysts who are most sensitive to the informativeness of others' actions are relatively more accurate in forecasting earnings, suggesting that the ability to extract information from the actions of others serves as a source of expertise for at least some analysts.

Financial analysts, earnings forecasts, market efficiency, learning

Abstract:
We design an experiment to examine the influence of prior audit experience on subsequent reporting decisions when auditors become managers of audited firms. In contrast to the independence issues that can arise when auditors and their clients are related by prior affiliation, we focus this study on the more common case in which auditors assume subsequent employment with other firms' clients. In a bi-matrix experimental game that captures key features of the tension between auditors and reporters, we find that reporters who have experience as an auditor are more sensitive to large penalties for misreporting than are reporters who have the same amount of experience exclusively in the reporter role. This finding is particularly strong among reporters who were relatively diligent in their former role as auditors. These results suggest implications for regulators in predicting the effects of changes in the consequences of aggressive reporting behavior, and for firms in deciding whether to employ individuals who have CPA experience in positions with corporate reporting responsibility.

Experiments, reporting, auditing, experience, own-payoff effect

Abstract:
This paper investigates the effects of preferences on judgments in an investing context, where investors should be motivated to interpret information objectively, yet have clear preferences with respect to what the information they are evaluating conveys (i.e., a gain or a loss on their investment). The results of the experiment are consistent with theories of motivated reasoning that predict when and in what manner directional preferences affect how information is processed. Specifically, investors are motivated to agree unthinkingly with information that suggests they might make money on their investment, but disagree with information that suggests they might lose money. In disagreeing, long investors expect earnings to be relatively high and short investors expect earnings to be relatively low. These results have implications not only for understanding investor behavior, but also for understanding the biased behavior of market participants who face conflicts of interest, such as analysts, managers, and auditors, by providing direct evidence that such behavior can arise for purely psychological reasons.

Abstract:
This paper reports the results of an experiment showing that investors' forecasts of earnings are affected by the investment positions they hold and by whether they are facing the prospect of a gain or loss on those investments. The results are consistent with theories of motivated reasoning that predict when and in what manner directional preferences affect how information is processed. Specifically, investors unthinkingly accept information that implies a gain for their investment, but disagree with information that implies a loss. In addition to the asymmetry in when investors are skeptical of information, investors are also biased in how they disagree: long investors expect higher future performance and short investors expect lower future performance. These results have important implications for understanding not only investor behavior, but also the behavior of market participants who face conflicts of interest, such as analysts, managers, and auditors, by providing direct evidence that such behavior can arise for purely psychological reasons. By providing evidence on how information processing is affected, the findings suggest testable predictions for accounting "fixation" effects and for the association of price and forecast biases with the favorability of public information, market-wide short interest, forecast dispersion, and trading volume.

Motivated reasoning, independence, optimism, forecast bias and dispersion

Abstract:
Implicit employment contracts are a common way to motivate firm productivity but also require that employees trust management to be fair when allocating post-production firm resources between employees and owners. We use an experiment to study the problem of motivating firm productivity, which depends on levels of both owner investment and employee productive effort, when managers have an incentive to favor the owner's interests over those of the employee. Drawing on research in psychology and behavioral economics, we argue that reputation formation is necessary but not sufficient for promoting firm productivity if manager compensation is highly sensitive to how much the owner is allocated after production occurs. Consistent with our predictions, allowing reputation formation does lead to greater firm productivity and higher payoffs for all firm members, but only when manager pay is relatively insensitive to the owner's ex post allocation. In addition to offering testable empirical implications, our theory and results are important because they can help explain why executive compensation is, in practice, surprisingly insensitive to owner returns, particularly when executives are responsible for maintaining long-term implicit employment contracts.

Abstract:
Analysts and the financial press are often accused of paying too much attention to one another, instead of providing their own independent analyses of fundamental information. Prior research suggests that such mutual observation can render consensus forecasts too extreme, more redundant, and less informative, and that investors will fail to anticipate these effects, leading investors to hold overly extreme beliefs with excessive confidence. We find that mutual observation in a laboratory setting does increase the extremity of consensus forecasts, but not excessively, and improves accuracy when incentives for accuracy are high as a result of the target firm experiencing recent abnormal performance. A second experiment shows that investors account appropriately for the effects of mutual observation. Overall, the results are consistent with an economic model in which analysts and investors are effort-averse Bayesians.

Abstract:
This paper reports the results of an experiment showing that individuals who have stakes in the earnings performance they are forecasting tend to generate forecasts that are more dispersed and more biased when the news they are evaluating indicates earnings performance inconsistent with their preferences. These effects work partly through participants' beliefs about potential bias in the news they evaluate. Participants who prefer lower earnings are more skeptical of optimistic bias in news and provide lower forecasts than participants who prefer higher earnings.

After controlling for the effect of participant beliefs about biased news, the forecasts of participants with a preference for lower (higher) earnings performance are still relatively pessimistic (optimistic). Forecasters also take the preference-consistent news more at face value, whereas they rely relatively more on their idiosyncratic beliefs when news is preference inconsistent. Because beliefs about optimistic bias differ across individuals, preference-inconsistent news induces more dispersed forecasts by magnifying that source of disagreement. Because their beliefs are influenced by the direction of their earnings preferences, preference-inconsistent news also induces more biased forecasts by magnifying that source of bias. Stakes, therefore, lead to predictable bias and dispersion. This bias-dispersion link provides an ex ante predictor of bias in forecasts because forecast dispersion is immediately observable, whereas bias is only measurable ex post. These results shed light on the causes of dispersion in forecasts and suggest directions for analytical models of heterogeneous beliefs.

EPS forecasts, forecast optimism, forecast dispersion, financial analysts, motivated reasoning