Solution Manual

to accompany

Contemporary Issues in
Accounting
Michaela Rankin, Patricia Stanton,
Susan McGowan, Kimberly Ferlauto
& Matt Tilling
PREPARED BY:

Patricia Stanton

John Wiley & Sons Australia, Ltd 2012

Solution manual to accompany: Contemporary Issues in Accounting

CHAPTER 8

CAPITAL MARKET RESEARCH AND ACCOUNTING

Contemporary Issue 8.1 Economists and the global financial crisis

1. Who was John Maynard Keynes? (K)

John Maynard Keynes was a British economist who influenced the theory and practice of
macroeconomics (Keynesian economics), as well as the economic policies of governments.
Refining the existing work on the causes of business cycles, he advocated the use of both
fiscal and monetary policies and measures to mitigate the adverse effects of economic
recessions and/or depressions.

2. To what does the author attribute the causes of the global financial crisis? (K)

The author attributes the causes to two dimension, one microeconomic and the other
macroeconomic. The microeconomic refers to “the epoch of privatisation, public-private
partnerships and market-mimicking arrangements of many different types, all based on the
assertion that ‘state failure’ was invariable a more serious problem than market failure”. The
macroeconomic dimension has two parts. “The first was a belief in the underlying stability of
the (private) capitalist economy, if it was not disturbed (‘shocked’) by mistaken government
intervention. The second was a belief in the efficiency of financial markets, which therefore
required only the lightest of government regulation, if any at all”.
3.
3. How did the efficient market hypothesis contribute to the crisis? (J, K)

Belief in the EMH lead to much deregulation of national and international financial
transactions, deregulation which encouraged “foolhardy behaviour on a massive scale by
large corporate players in financial markets and in discouraging any serious attempt at
governmental regulation”.

Contemporary Issue 8.2 Mathematical models

1. If mathematical models were abandoned, what could replace them? (J)

Models would probably be expressed in verbal terms with accompanying diagrams or

flowcharts - a back to the future solution.

2. Discuss whether mathematical models are better to be partly right rather than totally
wrong. (J)

Discussion should include the realisation that no model is likely to be completely accurate,
that there is a need to test models before they are put into use, and that users of the model
should understand what has been simplified in the model and the ramifications of that
simplification.

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3. Should decision makers be more mathematically literate so that they understand the
limitations of the models they use or should the models be extensively tested before
use? (J)

Both alternatives could be defended.

Contemporary Issue 8.3 Road to wealth may lie in marching out of step

1. Why should the price you paid for a share be irrelevant to your decision to hold it, or
to sell that share? (J)

Because what you paid for a share is in the past. As the author notes, “there is nothing you
can do to change it, so you should ignore it”. Economists call it a ‘sunk cost’ and so it is
‘irrelevant information’. The only thing you can hope to do is to influence the future, so the
future is what a buyer of a share should focus on, particularly the question, “do I know of any
other share (or other investment) that offers a better prospect of gain than the share I’ve got
my money in now?”
J
2. What is meant by the phrase that ‘people are loss averse’? (J, K)

The phrase, ‘loss averse’, refers to the finding that people are highly reluctant to crystallise a
paper loss by selling up but are willing to take more risks to avoid losses than to realise gains.

3. Explain ‘anchoring’. How does anchoring contradict the efficient market hypothesis?
(K, AS)

Anchoring is the obsession with the price paid for something such as shares - decisions are
made based on this single figure that should have little bearing on the decision whether to
hold or sell those shares.

Anchoring contradicts the EMH because when analysts are faced with new information that
contradicts their forecast, they tend to dismiss that information as a short-term phenomenon
whereas
the EMH holds that all new information is almost instantly incorporated into the market and
reflected in share prices.

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Solution manual to accompany: Contemporary Issues in Accounting

Review Questions

1. Explain what is meant by an ‘efficient market’.

An efficient market is one in which share prices reflect fully all available information.

2. Distinguish an event study from an association study.

An event study examines the changes in the level or variability of share prices or trading
volume around the time when information is released. This information is assumed to be
information new to the market if share prices or trading volume reacts to this information. In
contrast, an association study aims to see how quickly accounting measures capture changes
in the information reflected in share prices over a given period.

3. Explain why accounting earnings do not capture all the information contained in
share prices.

Accounting earnings do not capture all the information contained in share prices because they
are calculated using the conservative principles of revenue realisation and expense matching
which do not recognise all the events that are incorporated into share prices. Additionally,
these principles result in bad news being disclosed in a more timely manner than good news,
reflecting the less stringent accounting recognition criteria for bad news.

4. Explain how accounting’s recognition and realisation principles affect the

relationship between earnings and share prices.

Accounting’s recognition and realisation principles are conservative and backward looking so
that they do not allow the recognition of all events that investors use to make predictions
about future performances of the reporting entity.

5. What is meant by the term ‘post-earnings announcement drift’? What implications

does this phenomenon have for the efficient market hypothesis?

‘Post earnings announcement drift’ refers to the evidence that stock markets underreact to
earnings information — there is not an instantaneous, complete reaction to value-relevant
information but rather a gradual adjustment to the information. This gradual adjustment
contradicts the EMH which assumes that markets react instantaneously and completely to all
value-relevant information.

6. In what ways are the finance definition of ‘relevance’ and the conceptual
framework definition provided in chapter 2 similar?

According to the finance literature, an item of information is relevant if it has the ability to
make a difference to the decisions of users of that information so that these users modify their
expectations about future payoffs or associated risk. Accounting definitions of relevance refer
to information which influences the economic decisions of users by helping them either

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predict or confirm their past evaluations or past events. In both definitions, users are expected
to modify their beliefs based on the information.

7. When is an accounting number said to be ‘value relevant’?

An accounting number is assumed to be value relevant only if the amount reflects

information relevant to investors in valuing an entity, and if the amount is measured reliably
enough to be reflected in share prices.

8. Explain why earnings are not good measures of value relevance.

Accounting earnings capture only those events that pass the criteria for recognition. Investors
are assumed to focus on all events that affect future cash flows of an entity. Additionally,
accounting earnings can be negative which tells investors little about the future cash flow
generating ability of the reporting entity.

9. International accounting standards are conservative in their treatment of

intangibles. Will this conservative treatment conflict with investors’ perceptions of
the value of intangibles to a firm?

Accounting’s conservative treatment of intangibles (largely they are expensed) conflicts with
investors’ perceptions of the value of intangibles to an entity. The costs of intangible assets
have been shown to be relevant to investors, but investors perceive the expenditures as capital
acquisitions, in contrast to the accounting treatment of expensing such expenditures.

10. Summarise the main findings of the value relevance literature in relation to
accounting.

 The relationship between accounting earnings and share returns is weak.

 Accounting earnings do not capture all the information incorporated into share prices.
 Evidence on decomposed earnings and share prices is contradictory.
 Investors seem to value fair value accounting more than historical amounts.
 Consolidation improves the value relevance of earnings.
 There is information content in earnings announcements.

11. What principles are blamed for financial statements being poor indicators of value?
How do these principles inhibit valuation?

Revenue recognition and expense matching are blamed for financial statements being poor
indicators of value. These principles inhibit valuation because they favour the recognition of
bad news over good news.

12. Read the section on earnings management in chapter 6. How does that view of
earnings management differ from the view held in the finance literature? Why
would investors react positively to earnings management?

When managers use accounting choices to bias disclosures, the choice is called earnings
management. Earnings management doesn’t affect cash flows, therefore, investors, who are
assumed by the EMH to see through opportunistic accounting choices, will not alter their

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Solution manual to accompany: Contemporary Issues in Accounting

assessments of associated share prices. However, investors may react positively to earnings
management because they are unable or unwilling to unravel the effects of earnings
management. Investors have been shown to react positively to ‘big bath’ accounting because
it allows improved performances in subsequent periods.

13. What is prospect theory? What are the implications of prospect theory for finance?

Prospect theory is based on the simple idea that the pain associated with a given amount of
loss is greater than the pleasure derived from an equivalent gain so that investors attach more
importance to avoiding a loss than deriving a gain. Researchers finding evidence of market
inefficiency draw on prospect theory for support in arguing that investors are not rational.
Because rationality is one of the assumptions of many of the models used in finance, those
models will not predict accurately if investors do not act rationally.

14. In the literature on which this chapter is based, the notions of the efficient market
hypothesis and the CAPM are referred to as a ‘paradigm’. Findings that conflict
with these hypotheses are called ‘anomalies’. Find definitions of these terms. How
do they explain the progress of knowledge in the finance discipline?

In these circumstances, a paradigm is usually defined as a set of concepts, principles, ideas

and such shared by a community of scholars. An anomaly is a deviation from the commonly
accepted tenets of a paradigm. An increase in the number of anomalies weakens faith in the
paradigm. At some point, another paradigm may replace the existing one. It is akin to
evolutionary principles — a better explanation will replace a weaker one.

In the finance discipline, if anomalies reach a critical point where the EMH is no longer seen
to offer a satisfactory explanation, then another explanation will take its place — an
explanation which is accepted by a greater number of scholars than those still accepting the
EMH.

15. Behavioural finance, in contrast to mainstream finance, focuses on what aspects of

capital markets?

Behavioural finance focuses on decision making under uncertainty and, unlike mainstream
finance, on the decision makers, using the cornerstones of cognitive psychology and the
limits to arbitrage. The limits to arbitrage suggest that low-frequency market evidence does
not support market efficiency and the rationality of investors.

16. What does cognitive psychology tell us about investors?

Cognitive psychology tells us that:

 investors are not rational

 they make systematic errors in the way they think
 investors use heuristics to make decision making easier
 investors, especially male investors, are overconfident about their abilities
 they place too much reliance on recent experience

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 investors are influenced by the way information is presented, so that good image and high
awareness associated with a particular company results in a lower perception of risk
 investors avoid realising paper losses but seek to realise paper gains
 investors’ evaluation of returns is distorted by the size of the anchor they use as a starting
point for the evaluation
 investors’ emotions affect their risk-return perceptions and investment behaviour.

17. Does cognitive psychology supply explanations of why investors have flocked to
subscribe in high-profile companies such as Woolworths or Telstra?

Companies such as Woolworths and Telstra have high brand awareness within the Australian
market. Cognitive psychology suggests that the brand and image awareness of these
companies will result in investors perceiving them as a lower risk investment than other less
high profile companies.

18. Evaluate whether behavioural finance is able to explain the main anomalies of
efficient markets.

Student evaluations will depend on the evidence used by the student to support their position.

19. What are heuristics? How can they lead to poor decision making?

Heuristics are the rules of thumb used by decision makers to make decision making easier.
Affect heuristics suggest that positive emotional associations with a particular company will
result in that company being a lower perceived investment risk. Other heuristics relate to an
investor’s past experience — they place too much weight on that experience so that they
place too little weight on long term experiences. Other heuristics separate decisions that
should be combined.

20. How would you evaluate large amounts of research findings that are based on
associations, without much theoretical underpinning? O 6

Answers to this question depend on the standpoint taken. For example, the use to which the
associations are put will determine how these research findings are evaluated. If the findings
are reasonable predictors of future events, then they may be valued by those using them as
predictors.

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Solution manual to accompany: Contemporary Issues in Accounting

Application Questions:

8.1 Marcus Padley, a stockbroker, made the following statements in an article in the
Sydney Morning Herald. (J, K, AS, CT)

I love ‘The Warren Buffet Way’. In fact, one of my first clients introduced himself by
saying, ‘I am Fred and I’d like to invest the Warren Buffet Way’. Well whoopee do!
What shall we do? Get the annual reports of the top 200 companies. Analyse the
accounts of each, assess ‘value’ and then go to the stock market and find out that ‘wow,
I’m right and the whole market is wrong’ and the share price is trading below the true
‘value’. Then purchase the shares and wait for that value to inevitably emerge.

In fact most Warren Buffett-based approaches are terrible at timing, which in reality is
about the only thing that really matters. In an increasingly impatient market it is not
just about ‘what’, it is becoming all about ‘when’. Investors who sat through the
54.5per cent fall in the market in the financial crises need to earn 113% to get their
money back. That’s 13 years of compounding average annual returns. Not caring about
‘when’ just cost us 13 years.

(a) Critically evaluate the two statements made by Marcus Padley in the context of
capital market research. J

In relation to the first statement, a critical evaluation should take into account that
 EMH says that share prices reflect all available information – the client is assessing
available information
 The accounts in the annual reports are based on accounting principles which do not
capture all the information relevant to share prices, particularly information about
intangibles which make up a high proportion of the assets held by many listed firms
 Earnings management may distort the accounts.

In relation to the second statement, a critical evaluation should focus on behavioural finance
– investors do not sell early enough. Behavioural finance says that investors will try to avoid
the loss by holding onto their shares hoping for a rise in the market.

8.2 In December 2008, OZ Minerals wrote down its assets by $201 million. In its
2010 accounts it reversed this impairment charge, recording an increase of
$141.1 million to net profit. The impairment reversal was a non-cash adjustment
— it did form part of OZ Minerals’ operating earnings. As a result, the market
was reported to have found the reversal of historic interest only. However, after
the announcement of its 2010 earnings, OZ Minerals’ share price outperformed
the broader mining market, rising by over 3%. (J, AS)

(a) If the reversal was of ‘historic interest only’, how can the share price
reaction be explained?

Intuitively, the increase in net profit should result in an increase in the share price as an
increase in net profit is good news; good news is expected to increase share price. The
impairment reversal may have been part of earnings management. The EMH suggests that
investors should see through cosmetic earnings management but behavioural theory suggests
otherwise. Investors decisions are multifaceted, easily changed and seek satisfactory solutions
rather than optimal ones. Perhaps the 2010 earnings announcement was “satisfactory”.

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8.3 In September 2008, the Seven Network revealed it had incurred losses on its
strategy to ‘park’ hundreds of millions of dollars in listed securities which were
the result of the sale of half of its TV and magazine interests to a private equity
firm, a strategy which the company had not revealed to the market. Seven’s
share price closed at its lowest level since January 2005. (J, K)

(a) What is a ‘private equity firm’?

A private equity firm is an investment manager that makes investments in the equity of
companies through a variety of investment strategies including leveraged buyouts and
venture capital. It raises funds that will be invested in accordance with one or more specific
investment strategies and will receive periodic management fees as well as a share in the
profits earned from each of its managed funds. One of their well known strategies is to
acquire a controlling position in a company and then look to maximize the value of that
investment.

(b) Why do you think the share price fell? J

Probably due to investors finding out about the transaction whether by insiders who publish
investor news sheets, or though disclosure by non-Seven media.

(c) Was it a response to the lack of disclosure? J

Debatable, but probably to the fact that the Seven Network revealed the losses.

(d) Was it a response to the losses incurred by the strategy? J

Intuitively, that is a possibility, although post earnings announcement drift suggests that
because the announcement was of losses, the fall in the share price should have been delayed.

8.4 Talking to the financial press about the David Jones 2010 earnings from its
department store business, its CEO acknowledged that it had been a tough time
for the company due to the departure of its former CEO after sexual harassment
claims against the former CEO. The current CEO said the company should be
judged on two indicators: sales and share price. He distinguished between the man
(the former CEO) and the David Jones’ 170-year old brand. David Jones’ shares
rose 2%.

(a) Do you agree that a company such as David Jones should be judged on sales
and share price? (J)

Answers will depend on the point of view adopted. Shareholders who want dividends and
capital gains would favour sales and share price. Stakeholders would be wider in their views,
judging a company from a corporate citizenship perspective.

(b) Why is the distinction between the ‘man’ and the ‘brand’ important? (AS)

The brand is longer lasting. CEO life expectancies are short especially if they do not deliver
on what the Board of Directors want.
S

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Solution manual to accompany: Contemporary Issues in Accounting

(c) If brands are so important to a company’s share price, why are internally
generated brands not recognised under accounting rules? (AS)

Accounting standard setters are conservative in relation to intangibles such as brands. See the
chapter on special reporting issues.

8.5 The behaviour of the former CEO of David Jones apparently did not impact the
company’s share price. However, according to a study by two American economists,
the transgressions of Tiger Woods were responsible for wiping up to $US12 million
off the value of his sponsors (Gatorade, Nike, Gillette, Electronic Arts). Gatorade
and Nike were the worst hit of his sponsors.

(a) How can this apparent contraction between the impact of the David Jones’
CEO and Tiger Woods be explained? J

Tiger Woods was promoted as the personification of the ideals that were built into the brands
of companies such as Gatorade and Nike. When he was shown not to incorporate those
ideals, the share price was punished for those companies probably for using him as their
brand image. The DJ’s CEO did not feature in advertisements for the store and its owning
company. The media also suggested that the Board’s decisive move to remove him as CEO
reflected well on shareholders, hence the lack of punishment of the share price.

(b) What does the impact on sponsors’ shares say about the adage that ‘any
publicity is good publicity’? J

In this case, the adage did not apply.

8.6 Read accounting standard AASB133/IAS33 Earnings per Share and answer the
following questions.

(a) How is earnings per share calculated? (K)

EPS is calculated by dividing profit or loss attributable to ordinary equity holders of the
parent entity (the numerator) by the weighted average number of shares outstanding (the
denominator) during the period.

(b) What are some of the allocations, predictions and wild guesses that go into the
calculation of net income? (K)

 Definitions of income, revenue, and expenses which exclude certain transactions

 Recognition criteria which excludes further transactions
 Allocations of revenues and expenses to prior or future periods
 Depreciation calculations

(c) In light of the allocations, predictions and guesses, how reliable do you think
the earnings per share are as a summary of a firm’s activities for a period? (J,
AS)J A

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 Chapter 8: Capital market research and accounting

Students should address the meanings of “reliable” both from a dictionary meaning and the
accounting meaning. Answers will depend on how well the student can support their
argument.

8.7 For the 2010 financial year, Phoslock Water Solutions had:

• Revenues from ordinary activities up by 79%.

• Earnings before depreciation, amortisation, tax and interest improved by
40%.
• Net loss for the period improved by 33% over the previous year’s loss.

(a) What would you intuitively expect to be the market reaction? (J)

Intuitively the share price should have risen.

(b) Over the following two weeks, the company’s share price fell by a third. The
directors could not offer a business reason for the fall. Can you suggest a
reason(s) for the fall? Explain your reasoning. (J, AS)

Answers should be assessed by the student’s argument behind their explanation.

8.8A Geoffrey Hill, a private share consultant, made the following statements.
Comment on each statement, noting that some might require some research on
your part.

(a) First statement:

The trouble with all of this overseas money flowing into our market and pushing
it to new levels is that overseas investors have different views on what ‘value’
means. The sheer weight of money obviously increases share prices but the
institutions investing for overseas investors have scant regard to the level of risk
that they are adding to everyone’s portfolios.

(i) What do you understand by ‘value’ in the context of this statement? (SM)S

Different answers are to be expected.

M
(ii) What is a portfolio? What role does risk play in the composition of a
portfolio? (K)

A portfolio is a number of different shares selected to achieve a particular purpose such as the
minimisation of risk associated with share ownership. By diversifying the shares in the
portfolio, risk is average across the shares. However, portfolios can contain only low risk
‘blue chip’ shares.

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Solution manual to accompany: Contemporary Issues in Accounting

(b) Second statement:

We have become accustomed to low oil prices, over the past 20 years. This has
created a disincentive not to develop alternative energy supplies due to
economics. But it is a different story now with the oil price near $US50 a barrel.
Pacific Hydro operates hydro and wind farms in Australia, Chile, Fiji and the
Philippines. As new projects come on line, the economics and profit become
stronger. It is trading on a P/E of 16 and dividend yield of 1.4 per cent. There is
no value here for the Chartist’s Portfolio so we will not be investing.

(i) What is a ‘Chartist’?

A chartist is a share market analyst who plots the price trends of shares on charts to deduce
trends which will give an indication of what the markets will do in the future. Identified
trends are used for buy and sell decisions relating to those shares.

(ii) What makes his or her share purchasing decisions distinctive? K

Chartists believe that all significant information about a company’s performance is already
reflected in its share price, and so the study of price movements will provide the key to
investment decisions. Other tools used by investment analysts are not used in their decision
making.

8.9 The listed investor, Djerriwarrh, had a solid year in 2009, but not according to IAS
rules. Its net operating profit rose by 21.1% despite holding nearly 29% of its
portfolio in bank shares. Because of AASB139/IAS39 Financial Instruments:
Recognition and Measurement, it had to report a pre-tax ‘impairment’ charge of
$70.9 million and a net charge of $49.7million pushing its results to a loss of $14.1
million. Shares in the Djerriwarrh portfolio qualified for the charge, shares that
were not even remotely close to going broke but were impacted by the global
financial crisis share market rout. The problem is that as share prices recover,
impairment charges already taken against earnings cannot be reversed.

(a) Does the accounting impairment rule, as it stood in 2009, make sense? (J)

No, it did not as the companies in which Djerriwarrh had shares (AMP, Brambles and AIG)
were not likely to go broke. The rule did not envisage a share market crisis of the size of that
generated by the GFC. The rule also did not make sense in that reversals in the share price
(future gains) had to by-pass the profit and loss (income) statement, being taken to the
balance sheet as adjustments to reserves.

(b) What changes were made to AASB139/IAS39 Financial Instruments:

Recognition and Measurement as a result of the unforeseen consequences such
as that suffered by Djerriwarrh? (K)

The main change was to allow companies like Djerriwarrh to book changes in the value of
their shares against balance sheet reserves.

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(c) As a result of the changes, will investment companies that book impairment
losses to the balance sheet be able to report dividend income as income? (K)S
CTLO 7

No, they are no longer able to report dividend income as income!

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Solution manual to accompany: Contemporary Issues in Accounting

Case Study Questions

Case Study 1 Who needs credit ratings? They should be optional

1. What is the function of a credit rating agency? (K)

A credit rating agency is a company that assigns credit ratings for issuers (companies,
governments, banks and such) of certain types of debt obligations as well as the debt
instruments themselves. Issuers are organisations issuing debt-like securities that can be
traded on a secondary market. A credit rating for an issuer should take into consideration the
issuer's ability to pay back a loan. The credit rating affects the interest rate applied to the
particular security being issued.

2. Why have these agencies prospered? (J)

As noted in the case study, these agencies have prospered because “government regulators,
through the Basel II bank regulations to take one example, have in effect required all
companies and countries to have credit ratings that indicate how likely a particular entity is to
default... The world’s largest rating agencies, which enjoy regulatory clout, Standard &
Poor’s, Moody’s and Fitch, have grown fat and powerful on the back of these mandates”.

3. Why do credit ratings ‘underpin the world’s financial system’? (K)

As noted in the case study, for regulators, ratings are a simple and cheap way to monitor and
compare the riskiness of financial institutions. The popularity of ratings as a simple and
cheap way to monitor financial institutions mean that they now underpin the world’s financial
system so that ratings now critically influence the composition of every bank’s balance sheet.
K
4. Can you offer reasons why credit rating agencies would have valued US sub-prime
mortgages as AAA? (J, K)

Because the issuers of the sub-prime mortgages would have paid the credit rating agencies for
the rating. The complex nature of the sub-prime mortgages would have helped also to mask
the risk associated with them.
K
5. Why does the author have a low opinion of credit ratings? (J, K)

Because “the agencies rarely disagree with each other, they are paid exclusively by borrowers
who hanker for higher ratings, their regulatory sinecure protects them from any competition,
and as mere opinions, they cannot be held legally accountable for stuffing up”.
6. J K
6. What is meant by ‘moral hazard’? (K)

Moral hazard as a special case of information asymmetry in that it refers to a situation in

which one party in a transaction has more information than another. Moral hazard occurs
when the party with more information about its actions or intentions has a tendency or
incentive to behave inappropriately from the perspective of the party with less information.

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7. Explain the statement that the finance sector is ‘replete with moral hazard and
chock full of malign incentives’. (J, K)

Need to explain that moral hazard is information asymmetry – the borrower knows more
about their ability to repay a loan than the lender, and therefore has incentives to deceive the
lender in order to gain the loan.

8. Can you suggest why making credit ratings optional would ‘cure these
perversions’? (J, K)

Because the finance sector would have incentives to make risk assessments rather than pay a
credit rating agency to do it for them.
K
9. Research the following:

(a) The author is a research fellow of the Centre for Independent Studies. Is this
Centre ‘independent’? (J, K)

The Centre’s website proudly states that the CIS is actively engaged in supporting a market
economy and a free society under limited government where individuals can prosper and
fully develop their talents.

(b) How have ratings been used to regulate the investment decisions of local
government? (J, K)

The NSW Local Government Act restricted the investment decisions of local government to
securities which were rated AAA (the highest rating assigned by the rating agencies).

(c) How have the ratings resulted in large investment losses for many NSW local
governments? (J, K)

Many NSW councils claim they were misled by representatives of the ratings agencies who
said that the products, CDOs and other credit derivatives, were rated AAA. According to
newspaper reports of the action taken by NSW local governments against the rating agencies,
not only did the raters and vendors know of the extreme risk of the products the councils
were buying but they did not properly disclose the risks to the councils. They were
fundamentally misled”. With the Global Financial Crisis, councils lost millions on the
purchase prices of these AAA rated “investments”.

Case Study 2 Women take more risks when investing: survey

1. What do you understand by a ‘life cycle theory of investing’? Does the research by
BT and UWA support this theory? (J, K, AS)

The life cycle theory of investing posits that persons choose planning horizons which shorten
as individuals get older. During their lifetime, individuals will also reassess their portfolios,
the time between reassessments being determined by their wealth and the ways in which they
hold that wealth. At each stage in their lifetime, individuals must determine the mix of

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consumption, wealth tied up in risky assets and the amounts they wish to spend on leisure
purchases.

As an individual ages, the amount of their wealth tied up in human capital declines, the
amount that is investment in risky assets also declines as their flexibility to work longer,
change jobs etc decreases. In the case study, this is reflected in younger individuals holding
more growth (riskier) assets than older individuals.

2. How does being wealthy affect investment choices? (J)

The theory suggests that wealthier individuals are prepared to take more risks — the more
wealthy an individual is, the greater the holding of risky assets.

3. What other factors seem to affect investment activity? (K)

Age and gender

4. How do the findings by BT and UWA differ from the findings and predictions of
behavioural finance? (J, AS)

 In contrast to the predictions of behavioural finance, the BT, UWA respondents did not
hold on to their losing investments and sell their winning investments;
 Female investors were more prepared to invest in risky assets than their male counterparts.

5. In what ways do the BT and UWA findings confirm or deny the predictions and
findings of behavioural finance? (J, AS)

Many of the cornerstones of behavioural finance are neither confirmed or denied by the BT,
UWA findings. Those which are contradicted are those relating to buy/sell strategies and
investment behaviour linked to gender.

© John Wiley and Sons Australia, Ltd 2012 8.15