Hidden information, hidden action and the stock market

By Peter L. U
13 February 2018  |   The Manila Times

In 2001, George Akerlof, Michael Spence and Joseph Stiglitz were awarded the Nobel Prize in Economics for their work on asymmetric (or hidden) information and markets. Hidden information exists in a market when one or both parties in a transaction hold more or less information about the exchange than the other party. In his seminal paper, Akerlof used the second-hand (used) car market as an example. The seller of a used car normally has more information about his car (its defects and “warts”) than the prospective buyer because he uses it every day.

In many contexts, the presence of asymmetric information leads to the problem of hidden action or moral hazard. A classic context is a supervisor who can only monitor imperfectly the activities of a subordinate e.g. the latter is out in the field most of the time. The subordinate may be tempted to shirk or not exert full effort since it may be difficult to detect. Economists call this moral hazard, or also a principal-agent problem, since the supervisor (principal) faces a problem of how to get the subordinate (or agent) to act consistent with the principal’s interest.

What does this have to do with the stock market? The Philippine stock market ended 2017 with a bang, and this momentum has been sustained in the first few weeks of 2018, as the benchmark index climbed further and pierced the 9,000-point threshold. The buoyant economy and its rosy prospects should continue to boost the stock market and attract investors, including small investors. There is an estimated 600,000 stock market investors, majority of them small shareholders.

Shareholders of companies could be the principal in a principal-agent problem, with managers of the corporations as the agent. Owners would like to see the company’s profits go up so that the price of their stock rises and/or they receive cash or stock dividends. In some companies, because of built-in incentives, the managers may not necessarily act to maximize profits. For instance, they may seek to maximize revenue, instead, if their compensation, perks and benefits are tied to sales rather than profits. Or they may “slack off” in their running of the company to minimize their effort. In large publicly listed companies, the owners, and certainly small shareholders, would not be able to monitor well the efforts of the managers in running the business.

Probably the only opportunity of most stockholders to gauge how well the managers run the company is during the annual stockholders’ meeting, where the company’s performance and prospects are presented. Stockholders also have a chance to ask questions on the company’s presentation and vote for the board of directors at annual meetings.

Another example of asymmetric information in the stock market is the case of insider information, which refers to vital information on the company that only executives or managers may know, or be first to know. Trading on the basis of such information gives the “insider” undue advantage and is illegal. Those with inside information can buy additional shares if the inside information is favorable to the company, or start selling their holdings if the information is unfavorable. In the latter case, after the inside information becomes public, share prices are likely to drop and the poor unwitting buyer/investor suffers an instant loss. Individual investors may not be able to monitor and guard against this.

Small shareholders, thus, need protection. SharePHIL was organized to protect and promote shareholder rights and promote capital market development in the country.

Some early work of the SharePHIL research committee has focused on the conduct of annual stockholder meetings. Other research work includes setting criteria for good annual reports and qualifications for independent directors. Through these studies, SharePHIL seeks to make recommendations to improve the conduct of annual stockholder meetings, production of annual reports, and appointment of qualified Independent Directors so that the rights, voice, and access to information of shareholders, especially the small ones, are protected. In so doing, the equities market will further develop, as small investors gain confidence to participate in the market.

Peter L. U is vice-dean of the School of Economics of the University of Asia & the Pacific and member of the Research Committee of the Shareholder’s Association of the Philippines. This guest column is in collaboration with SharePHIL. Email: peter.u@uap.asia

Original URL Link: http://www.manilatimes.net/hidden-information-hidden-action-stock-market/379766/

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