information bias

Examples of information bias in the following topics:

• Implications and Limitations of the Efficient Market Hypothesis

  • The limitations of EMH include overconfidence, overreaction, representative bias, and information bias.
  • Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing.
  • Further empirical work has highlighted the impact transaction costs have on the concept of market efficiency, with much evidence suggesting that any anomalies pertaining to market inefficiencies are the result of a cost benefit analysis made by those willing to incur the cost of acquiring the valuable information in order to trade on it.
  • Despite this, Fama has conceded that "poorly informed investors could theoretically lead the market astray" and that stock prices could become "somewhat irrational" as a result.
  • Critics have suggested that financial institutions and corporations have been able to decrease the efficiency of financial markets by creating private information and reducing the accuracy of conventional disclosures, and by developing new and complex products which are challenging for most market participants to evaluate and correctly price.

• Limitations of Financial Statement Analysis

  • The efficient-market hypothesis (EMH), for example, asserts that financial markets are "informationally efficient. " In consequence of this, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.
  • While the weak form of this hypothesis argues that there can be a long run benefit to information derived from fundamental analysis, stronger forms argue that fundamental analysis like ratio analysis will not allow for greater financial returns.
  • Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing.
  • Other disadvantages of this type of analysis is that if used alone it can present an overly simplistic view of the company by distilling a great deal of information into a single number or series of numbers.
  • Also, changes in the information underlying ratios can hamper comparisons across time and inconsistencies within and across the industry can also complicate comparisons.

• Information Costs and Bond Prices

  • If investors need time and money to acquire information on securities, then they pay a greater information cost.
  • We can use the demand and supply analysis to create two markets for the high and low information- cost bond markets.
  • Investors pay a greater cost to acquire information for the high information cost bonds.
  • Thus, investors are attracted to the low-information cost bonds, boosting their demand for low information cost bonds, increasing the market price and decreasing market interest rate.
  • Therefore, low-information-cost bonds pay a lower interest rate.

• Signaling

  • A dividend decision may have an information signalling effect that firms will consider in formulating their policy.
  • Signaling took root in the idea of asymmetric information, which says that in some economic transactions, inequalities in access to information upset the normal market for the exchange of goods and services .
  • When investors have incomplete information about the firm (perhaps due to opaque accounting practices) they will look for other information in actions like the firm's dividend policy.
  • Miller and Rock pointed out that this is likely due to the information content of dividends.
  • Describe what information a shareholder can obtain from a company issuing dividends

• Signaling Consideration

  • Signaling is the conveyance of nonpublic information through public action, and is often used as a technique in capital structure decisions.
  • In economics and finance, signaling is the idea that a party may indirectly convey information about itself, which may not be public, through actions to other parties.
  • Signaling becomes important in a state of asymmetric information (a deviation from perfect information), which says that in some economic transactions inequalities in access to information upset the normal market for the exchange of goods and services.
  • In his seminal 1973 article, Michael Spence proposed that two parties could get around the problem of asymmetric information by having one party send a signal that would reveal some piece of relevant information to the other party.
  • In terms of capital structure, management should, and typically does, have more information than an investor, which implies asymmetric information.

• Role of Financial Markets in Providing Feedback to Management

  • Management often has imperfect information about its own business, especially its business' value in the outside world .
  • For example, investors who hold shares in multiple firms in a sector may have more information about the prospects in that sector than the manager of one firm in that sector.
  • In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other, creating an imbalance of power.
  • Financial economists have applied information asymmetry in studies of differentially informed financial market participants (insiders, stock analysts, investors, among others).

• The Efficient Market Hypothesis

  • The semi-strong-form EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information.
  • The strong-form EMH additionally claims that prices instantly reflect even hidden or "insider" information.
  • This implies that future price movements are determined entirely by information not contained in the price series.
  • In semi-strong-form efficiency, it is implied that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information.
  • In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns.

• Trend Analysis

  • Trend analysis consists of using ratios to compare company performance on an indicator over time, often to forecast or inform future events.
  • Trend analysis is the practice of collecting information and attempting to spot a pattern, or trend, in the information.
  • Often this trend analysis is used to forecast or inform decisions around future events, but it can be used to estimate uncertain events in the past .

• Answers to Chapter 9 Questions

  • Investors prefer to invest in securities that entail low information costs.
  • Thus, investors increase their demand for the low information cost bonds and decrease their demand for the high information cost ones.
  • Consequently, bond prices increase for the bonds with low information costs but increase for the high information cost bonds.
  • Furthermore, the interest rates are lower for the bonds with low information costs and higher for the other bonds.
  • Thus, the securities have the same risk, liquidity, information costs, and taxes.

• Interpreting Ratios and Other Sources of Company Information

  • Financial statement analysis uses comparisons and relationships of data to enhance the utility or practical value of accounting information.
  • Financial statement analysis, also known as financial analysis, is the process of understanding the risk and profitability of a company through the analysis of that company's reported financial information.
  • This information includes annual and quarterly reports, such as income statements, balance sheets, and statements of cash flows.
  • All financial analysis relies on comparing or relating data in a way that enhances the utility or practical value of the information.
  • As more information is added, such as the total amount of sales, the number of assets, and the cost of goods sold, the initial information becomes increasingly valuable, and a more complete picture of a company's financial activity can be derived.