Black swan events illustrate the limits of theory, the bounds of prediction and the fallibility of assump-

tions. On this basis, the expression is ideally suited to financial markets because they are unpredictable.
Because they are hard to predict they will probably cause a major shift in the perceptions of inves-
tors. With black swan events in the recent past, could others be lurking? Answers are hard to come by.
Neither market analysts nor media outlets are likely to be reliable guides for when and where potential
black swans might emerge again.
Commentators suggest that having strong convictions about shares or the stock market in the long
term is surely more foolish than believing something on a shorter time frame. The longer the time frame,
the more guesswork. They also suggest that thinking in terms of a long‐term promise or making a long‐
term judgement about a share on the basis of the available evidence is irrational.
In the end, not all swans are white. When shares are purchased, the research, assumptions and
expectations behind that decision are already history.
Sources: Based on information from Andrew Osterland, ‘Fight or flight? Threat of black swan events spooks investors’, CNBC;
Marcus Padley, ‘Truth about long‐term investment and black swans’, The Sydney Morning Herald; ‘Black swan’, Investopedia.71

QUESTIONS
1. What is a black swan event?
2. How do black swan events illustrate the limits of theory?
3. Why was the global financial crisis labelled a black swan event?
4. What advice can be drawn from financial market black swan events?

In their work, Kahneman and Tversky integrated psychology and economics, providing the intellec-
tual foundations of behavioural finance. Their focus was decision making under uncertainty, a charac-
teristic of capital markets. They demonstrated that decision making involves the use of heuristics and
systematically departs from the laws of probability. Modern finance involves little or no examination of
individual decision making. Deduction is prominent, so that decision making is a ‘black box’. Because
finance is concerned with prediction rather than description or explanation, finance theorists constructed
abstractions of the decision process.72
Investment decisions are characterised by high exogenous uncertainty because future performance
must be estimated from a set of noisy and vague variables. Investors who make decisions have an
intuitive, less quantitative, emotionally driven perception of risk than that implied by finance models.
Decision makers’ preferences tend to be multifaceted, easily changed and often only formed during the
decision‐making process. They seek satisfactory rather than optimal solutions. The typical investor can
be termed homo heuristics, not homo economics, a completely rational decision maker focused on utility
or wealth maximisation.73

Cornerstones of behavioural finance

An important cornerstone of behavioural finance is cognitive psychology. Because cognitive psychology
is the study of how people perceive, speak, think, remember, or solve problems, it suggests the following.
•• People make systematic errors in the way they think. They use heuristics or rules of thumb to make
decision making easier, which can lead to biases and sub‐optimal investment decisions.
•• People are overconfident about their abilities. Men are more overconfident than women. Entrepreneurs
are especially likely to be overconfident.
•• People put too much weight on recent experience so that they underweigh long‐term averages.
•• Mental accounting separates decisions that should be combined.
•• Framing says that how a concept is presented to people matters. This refers to the old adage about
whether a glass is half full or half empty and how each gives us a different perception about the
quantity in the glass.
•• People avoid realising paper losses but seek to realise paper gains. This behaviour is called the
disposition effect.

252  Contemporary issues in accounting

•• Anchoring says that people tend to rely on a numerical anchor value that is explicitly or implicitly
presented to them and use it as an initial starting point. When things change, people tend to be slow
to pick up on the changes as well as to underreact because of their conservatism. Any evaluation of
returns is distorted by the size of the anchor.
•• Representativeness says that people tend to rely on stereotypes — for example, past performances
are extrapolated without considering the exogenous uncertainty and randomness of financial markets.
Good brand image and high brand awareness result in a lower perception of investment risk.
•• Affect heuristic indicates that emotions affect risk–return perceptions and investment behaviour.
Positive emotional associations result in lower perceived investment risk.
Whether expertise moderates these outcomes is uncertain. Some findings show that investor exper-
tise has no influence on the use of heuristics.74 Other evidence suggests that individual knowledge has a
moderating effect.
These observations contradict the core theories of modern finance, which assume that:
•• investors are perfectly rational (or markets act as if they were)
•• markets are efficient
•• transaction costs are so small that informed traders quickly notice and take advantage of mispricing,
driving prices back to ‘proper’ levels.75
Behavioural finance argues that investors, based on these observations, are not rational, so that there
are observable biases. The list of biases is growing and includes:
•• overconfidence — the tendency of investors to overestimate their skills.
•• endowment effect — the tendency of individuals to insist on a higher price for something they wish to
sell, rather than to buy the same item if they do not already own it.
•• loss aversion — the tendency for people to be risk averse in relation to profit opportunities but to be
willing to gamble to avoid a loss.
•• anchoring — the tendency for people to make decisions based on an initial estimate that is later
adjusted, but not sufficiently adjusted to eliminate the influence of the initial estimate.
•• framing — the tendency to make different choices based on how the decision is framed, especially if
it is framed in terms of a likelihood of a good outcome or the reciprocal bad outcome.
•• hindsight — the tendency to read the present into assessments of the past.
Those who study capital markets are becoming increasingly disillusioned with the assumptions that
underlie the notion that markets are efficient. So what are the implications for accounting of markets not
being efficient and of behavioural finance? Accounting policy makers have relied on market efficiency to
make choices between accounting methods. How will the tenets of behavioural finance affect accounting
policy choice? This is one issue that relies on a ‘wait and see’ answer.

CHAPTER 8 Capital market research and accounting  253