An Exploratory Study Investigating the Mitigation of ...



An Exploratory Study Investigating the Mitigation of Individual Investors’ Belief Revisions and Order Effects

Robert Pinsker

Assistant Professor of Accounting

Old Dominion University

2140 Constant Hall

Norfolk, VA 23529

Phone: (757) 683-6553

Fax: (757) 683-3258

Email: rpinsker@odu.edu

I would like to thank Doug Ziegenfuss, David Hayes, and Ronny Daigle for their assistance in obtaining participants. I would also like to thank the Office of Research at Old Dominion University for funding.

An Exploratory Study Investigating the Mitigation of Individual Investors’ Belief Revisions and Order Effects

ABSTRACT

Sequential belief revisions in the financial reporting context have resulted in less-than-optimal decisions made by investors (i.e., order effects; Tuttle et al. 1997) and unintended stock price volatility for the investee firm (Pinsker 2004). This study investigates two alternative methods for mitigating belief revisions and order effects found in individual investors: continuous accountant assurance and written explanation. As demonstrated in the source credibility literature, accountant assurance helps add credibility to firm information, which should reduce the magnitude of belief revisions and occurrences of order effects. Explanation requires an individual to write down at least one reason why he/she is making the decision. The increased effort required is also believed in the literature to have similar effects on belief revisions as accountant assurance.

The results indicated that both continuous assurance and written explanation appeared to be effective mitigators of belief revision magnitudes for novice investors (undergraduate accounting students). If these individuals play a role in the existing volatility in the marketplace (due to their lack of investing knowledge and experience), then using assurance or explanation as mitigation techniques makes sense. With regard to the more experienced investors (MBA students), continuous assurance did not have a strong mitigation effect on their belief revision magnitudes. However, it did mitigate recency effects for both sequences of disclosures. There was mixed evidence regarding written explanation: belief revision and recency effects mitigation only occurred in one sequence of disclosures. Thus, although not as pronounced as for the novice investors, assurance and explanation did have some positive effects on more experienced investors.

This study is the first to consider mitigating belief revision magnitudes and order effects in an investing context. The results obtained could significantly improve investment decisions, while, at the same time, reduce volatility in the stock market. The study also adds significantly to the belief revision research and continuous assurance literatures by investigating individual, non-professional decision-makers in an accounting context. The exploratory nature of the current study allows for numerous future research opportunities to consider different mitigating factors, as well as investing samples.

Note to Reviewers: I am in the process of collecting more data using MBA students, as well as a third sample: business professionals. So far, this third sample has over 90% investing experience (most experienced investor proxy). Both sets of new data should be collected and analyzed by the conference in November.

INTRODUCTION

Hogarth and Einhorn’s (HE; 1992) belief-adjustment (BA) model has been used as the theoretical framework to extensively study belief revision and order effects in both the psychology and accounting domains.[1] In almost all cases, the model’s predictions have been supported. One limitation with this stream of research is that the focus has been on finding order effects, rather than finding ways to mitigate them.

Another limitation with existing BA model research is that it is almost exclusively focused on investigating belief revisions made by accountants (tax and audit). The reason may be due to the ability to instruct (through superiors) and regulate (through accounting regulators) in such a way as to “control” the observed biases (e.g., using a peer review process, working in groups, or requiring documentation). However, the existing stream of research fails to address the order effects found in the individual investor literature (e.g., Tuttle et al. 1997; Pinsker 2004), even though these investors use accounting information to make important decisions in a capital market setting. A possible reason for the research gap may be due to the lack of regulation over investors. Therefore, the purposes of this study are to identify and test realistic methods that would mitigate belief revisions and order effects in a financial reporting context.

According to the BA model, an individual’s sensitivity toward cues plays a large role in determining the magnitude of belief revision. Using source credibility theory and research findings on effort, this study attempts to find ways reduce an individual’s sensitivity to firm disclosures, which is then hypothesized to reduce the magnitude of belief revision and order effect. Specifically, the concepts of continuous assurance and explanation are used to attempt to mitigate belief revisions of individual investors.

The research methodology consisted of a 3 (mitigation technique: assurance, explanation, and control) by 2 (direction: four positive cues followed by four negative cues or vice versa) between-subjects design. Two series of experiments were run. The first experiment used upper-division, undergraduate accounting students and the second experiment involved MBA students completing a financial accounting course. Both sets of participants have been used in prior investing research (e.g., Tuttle et al. 1997 (undergraduates); Maines and McDaniel 2000 (MBAs)). A recent article (i.e., Ritt 2004) indicated the demographics of the “average” U.S. individual investor are quite varied: reflecting the need to use multiple proxies. MBA students typically have more business knowledge and experience than undergraduates, and thus, represent a different demographic of individual investors.

The results indicated that both continuous assurance and written explanation appeared to be effective mitigators of belief revision magnitudes for novice investors (i.e., the undergraduates). If their interactions in the marketplace result in increased stock price volatility (due to their lack of investing knowledge and experience), then using assurance and/or explanation as mitigation techniques makes sense. With regard to the more experienced investors, continuous assurance did not have a strong mitigation effect on their belief revision magnitudes. However, it did mitigate recency effects for both sequences of disclosures. There was mixed evidence regarding written explanation: belief revision and recency effects mitigation only occurred in one sequence of disclosures.

In sum, evidence is provided indicating both continuous assurance and required written explanation can be beneficial to the investing marketplace with regard to both experienced and inexperienced investors. Future research investigating other investing populations and mitigation techniques represent exciting opportunities to benefit both the accounting and investing populations. The rest of the paper is configured as follows. The next section discusses the related theory and research hypotheses. A discussion of the research methodology follows, with the results explained next. Finally, conclusions are discussed as well as study limitations and opportunities for future research.

THEORY AND HYPOTHESES

The Belief-Adjustment Model

Examining the BA model can identify the impact of a decision-maker’s sensitivity toward positive and negative information on the magnitude of belief revision. The algebraic form of the model can generally be written

[pic][2]

where

[pic] degree of belief in some hypothesis, after evaluating k pieces of evidence

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