Accounting Information, Disclosure and Expected Utility: Do Investors Really Abhor Uncertainty?

Abstract

Investors are said to abhor uncertainty, but if there were no uncertainty they could earn only the risk-free rate. A fundamental result in the analytical accounting literature shows that investors buying into a CARA-normal CAPM market pay lower asset prices, earn higher expected returns, and obtain higher expected utility, when the market payoff has higher variance. New investors obtain similar welfare gains from risk under a log/power utility CAPM. These results do not imply that investors abhor To realize investors' ex ante expectations, the subjective probability distributions representing market expectations must be accurate. Greater payoff risk can add to investors' expected utility, but higher ex post (realized) utility comes from better information and more accurate ex ante expectations. An important implication for accounting is that greater disclosure can have the simultaneous effects of (i) exposing more accurately firms' payoff uncertainty and thereby increasing new investors' expected utility, and (ii) improving market estimates of firms' payoff parameters (means, variances, covariances), thereby giving investors a better chance of realizing their expectations. Paradoxically, better information can be valuable to new investors by exposing more accurately the uncertainty in firms' business operations and results. New investors maximizing expected utility typically want both more uncertainty and better information.