The FINANCIAL — Investors are routinely being influenced by their biases when analysing the risk involved with putting money into a business, according to a new study.
The latest research from Aston Business School, based at Aston University in Birmingham, UK, found that the way a company describes how risky it is to invest in them can affect how investors perceive the opportunity.
For instance, a company that said ‘a 20% change in natural gas prices would change our profit by £2 million’ was perceived to be a risky bet by investors.
But when the percentage was lowered to say ‘a 1% change in natural gas prices would change our profit by £100,000’, this was seen as a far safer investment – despite the actual sensitivity remaining the same.
These theoretical predictions, known as sensitivity disclosures, are widely used by businesses to reveal how the economy and other factors might affect their financial position.
However, the study found that companies choose these hypothetical changes very arbitrarily, with many needlessly damaging their investor appeal.
Dr Ozlem Arikan, author of the study and Lecturer in Accounting at Aston Business School, said: “Sensitivity disclosures are very prevalent and previous research shows that people anchor on the numbers that are provided to them, so it really does matter how a company expresses this risk.
“In one psychology study, people rated cancer as riskier when it was described as ‘killing 1,286 out of 10,000 people’ than as ‘killing 24.14 out of 100 people’1 even though the latter conveys a far higher death rate. Our research has found that the same principle applies for investment risk.
“Overall, the study found that managers’ choices of hypothetical percentages in sensitivity disclosures are often arbitrary. Therefore, there’s a risk that investors could be misled. A wiser approach for companies would be to choose a hypothetical percentage that represents the environment. So for instance, if you expect that natural gas prices will move by 2%, use 2% rather than something arbitrary.”
Blinded by the light?
Dr Arikan also looked at whether investors always take sensitivity disclosures into account before making a decision. She found that this is not the case.
The study, published in Accounting and Business Research, found that when a company is performing very well and seen as an exceptionally good investment there is a tendency to ignore the risk.
“People tend to ignore information that doesn’t suit them,”2 Dr Arikan said. “An individual would typically like to invest in a promising company and deny the realisation of an adverse possible scenario.
“Interestingly, the study also found that investors’ judgements on risk in one scenario often spills over into another – even if they’re not related. In my study, participants read some information which showed that the move in oil and natural gas prices were not correlated to each other. Yet when asked their view on how oil prices would move in the upcoming year, they continued to anchor on the risk expressed in the sensitivity disclosure for natural gas.
“This shows that even when the information given is random or irrelevant, there remains a tendency to take it into account when making an investment decision.”
Dr Arikan added that it is important for investors to be aware of this phenomenon to ensure their decision making is as rational and logical as possible
“This research has implications for investors, companies, as well as regulators. Investor education programmes need to focus on these anchoring effects to reduce possible biases in decision making.
“Businesses need to be aware of how their sensitivity disclosures are being perceived by investors. It could be that one simple change could change how investors perceive the risk.
“There is also an impact for regulators, who could consider giving more guidance to companies about the hypothetical percentages used in these predictions to ensure that investment decisions are not affected by biases found in the study.”