Judson Caskey



It is no secret that there is plenty of money left on the table by average investors in securities markets around the world according to UCLA Anderson Assistant Professor Judson Caskey. Who leaves it there? Average investors who tend to ignore subjective or ambiguous factors concerning a firm's value and market price. Caskey describes this topic in an article in the Review of Financial Studies called, "Information in Equity Markets with Ambiguity-Averse Investors."

How do we know there is money left on the table? It is clearly indicated by the prevalence of firms designed to take advantage of mispriced equities, says Caskey. He cites a 2001 Journal of Accounting and Economics article in which Charles Lee referred to the African plains and stated that, "We cannot at once believe in the existence of lions, and reject the existence of the creatures that are essential to their survival."

"The specific form of mispricing I address in this paper," says Caskey, "would be when investors do not fully incorporate information that is available to them. Firms make all sorts of disclosures in their annual reports and, if investors fully impound that information, it should be reflected in the stock price so I should not be able to use a firm's 10-K to make a profitable bet. But studies have shown that you can make money. So that is what I refer to as 'mispricing.' Investors just don't fully impound information."

In an efficient market, stock prices would adjust quickly each time an annual report is issued, according to Caskey. "Within a short period after a firm releases its 10-K, investors will place bets based on what they learned from it and the firm's price will adjust in the process. The early movers will get a quick return." he says. After that, the stock should be priced correctly with no money left on the table.

But ambiguity causes the market to be less than efficient. Ambiguity arises when there's uncertainty that is purely subjective. "To give a contrast of what's objective, think about playing blackjack with a full deck of cards," says Caskey. "If you wanted to, you could compute the exact odds of getting a winning hand. So that would be objective uncertainty. Subjective uncertainty, on the other hand, might be trying to guess whether the price of a particular stock will go up or down. I can't compute the odds of winning that bet like I can with blackjack. It's going to be a subjective exercise.

"Let's say a company's income is higher this year than last," he continues. "Usually that's a good signal. But suppose you dig into the footnotes in their annual report and find out it's because they slashed their advertising. What do you do with that information? On the one hand, the cut in advertising could reflect efficiency, which would be good. Or this could cause their customer base to erode, which would be bad. This is a subjective situation in which some people aren't going to be comfortable making a bet."

Faced with ambiguity, Caskey believes that many investors rely on incomplete information such as earnings or price/earnings ratio. "They revert to more simple rules for their investment decisions," he says. "Ambiguity-averse investors in my model effectively say, 'I don't know what to do with the full set of information in the financial statements and footnotes, so I'll just base my investment decisions on a simple number like net income.' As a result, the stock price fails to impound all of the available information, which leaves money on the table for people who are more willing to act on their subjective judgments."

Caskey points out that there are varying degrees of subjectivity in the stock market. Life insurance firms, for example, are based on extensive data concerning life expectancy. "But think about firms developing a new medical treatment," he says, "This could lead to a cure-all or it could do nothing. It's highly subjective."

Talking about how ambiguity affects institutions, Caskey notes that the insurance market for marine shipments was highly subjective in the 16th century. "Insurance was expensive because you didn't know if a sea monster was going to gobble up your ship," he says. With time, risk became more objective since you could better quantify the chance of having a shipwreck or other mishap.

Caskey says that the ability to make investment decisions using subjective information is a crucial quality in an investment professional. "My guess is that if you're ambiguity-averse, you're probably not going to become a fund manager," he says. "If you are ambiguity-averse and all the information you have about a stock is subjective, that will make you nervous and cause you to place smaller bets. It's like risk where some people just have the stomach for it."

He says that ambiguity-aversion has been tied to the notion of home country bias among investors. "People in most of the developed world have their stock portfolios far overweighted in domestic stocks," he says. "There is risk in the U.S. economy, but few Americans diversify that risk away by buying non-U.S. stocks. It's the same in Japan, France and Germany and so forth. Other research suggests that this may be because investors perceive other countries' stock as having a lot more subjective risk."

But Caskey cautions that mispricing can be caused by factors other than ambiguity. "There are other forces out there that are not in my model," he says. "Consider the Internet bubble. People were willing to invest based on very subjective information."

Should firms make an effort to be less ambiguous in their financial reporting? "Firms could make their disclosures easier to interpret," says Caskey. "Everything should be tied to value. So, in the advertising example I gave, the firm should be clear about how the cut in advertising might impact future sales. This could help avoid conflicting interpretations. My model also suggests that efforts to require firms to expand disclosures may have a limited impact on prices. Investors may choose to simply ignore the information."

But he feels there are limits to how much a firm can control ambiguity. "Some aspects of markets are just inherently subjective," he says.