I investigate how the quality of accounting disclosure influences market efficiency in the context of stock markets as a Keynesian beauty contest, a metaphor first introduced by Keynes (1936). At that time, a London newspaper was running a beauty contest in which readers were asked to select a set of six “most beautiful” pictures from 100 photographs of women. Whoever picked the most popular pictures was entitled for a raffle prize. To win the competition, players should not naively select six faces they believed the most beautiful; instead, they should use their information to infer which faces other players would believe the prettiest and other players would believe that other players would believe the prettiest and so on. Keynes observed that stock markets shared the essence of this competition, in that many rational but short-horizon investors’ actions were similarly governed by expectations about what other investors believed, rather than by genuine expectations about the true value of a firm.
Allen, Morris, and Shin (2006) rationalize this Keynesian-beauty-contest effect as a consequence of investors’ short horizons. Since a short-horizon investor exits a firm before its fundamental value is known, her payoff depends on how much other investors would like to pay, rather than on how much she expects the fundamental value of the firm will be. Given access to both public and private information, she puts an extra weight on public information due to its dual role. Public information does not only convey information about the fundamental value (hereafter the information-content role), but also anchors an investor’s belief about other investors’ beliefs (hereafter the coordination role). This additional coordination role biases stock prices away from the consensus fundamental value toward public information.
Having qualitatively formalized the Keynesian-beauty-contest effect, Allen, Morris, and Shin (2006) also leave many questions open, one of which concerns the market efficiency consequences of disseminating public information in a Keynesian-beauty-contest stock market. How does the quality of public information affect market efficiency? How is the intensity of the dual role of public information related to its quality? Could the Keynesian-beauty contest effect justify the withdrawal of some noisy public information?
These questions are important to accounting researchers. The Keynesian-beauty contest effect introduces a new perspective to understand accounting disclosure. Accounting disclosure, as a main source of public information, is a unique feature of public firms characterized by dispersed ownership. Understanding accounting disclosure entails examining the consequences of dispersed ownership, among which agency problems and differential information have been the best known. However, dispersed ownership has other consequences that have profound impact on disclosure practice but have not received the attention they deserve. One of such examples is the Keynesian-beauty-contest effect. The effect results from investors’ short horizons, which in turn arise because dispersed ownership of modern corporations decouples the life span of entrepreneurs and owners from that of their firms.
In the absence of a formal rational interpretation of the Keynesian-beauty contest effect, conventional wisdom comes that transparency should be curtailed in a Keynesian-beauty-contest stock market. The logic goes as follows. As public information becomes noisy, its information content becomes tenuous. If its coordination role increases or at least does not decrease as public information becomes less precise, there could exist a threshold precision under which the diminishing information-content role is dominated by the non-decreasing coordination role. For example, Shiller (2000) criticizes that, news media, by promulgating noisy public information and thus creating “similar thinking among large groups of people”, exert undue influence on market events. The conventional wisdom, which usually claims support from Shiller (2000)’s criticism, could have immediate prescriptive implications.
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