Stocks that are more risky earn higher average returns. However, managers often manipulate accounting numbers to...

Stocks that are more risky earn higher average returns. However, managers often manipulate accounting numbers to smooth the volatility of their company’s earnings and try to make the company appear less risky. How can you explain this behavior?

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Expert Solution

It's true that Stocks that are more risky earn higher average returns. However the stocks that are more risky give rise to:

Volatile earnings
Which in turn leads to volatility in share prices
Which in turn leads to volatility in the returns

Investors and traders are therefore, in general averse to volatility in earnings as it leads to volatility in share prices that lead to trading losses for them.

They therefore prefer stability in earnings. Management knows this preference of investors and hence they engage into smoothening of the company's earnings and try to make company appear less risky.

This is definitely an unethical practice, but then there is an agency problem. Managerial compensation are linked to the stability and sustainability of the share prices. Their compensation is liked to the trends in the stock prices and their behavior. It therefore lures managers to smoothen the earnings and make the stock appear less volatile. This is the reason behind their behavior.

jeff jeffy answered 1 year ago

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