Monday, 12 September 2011

Investors’ Reliance on Analysts’ Stock Recommendations

Published on CAR

Regulators express concerns with investors’ unquestioning reliance on analysts’ recommendations, which prior research has shown to be associated with lower trading returns. Thus, regulators have published investor guides advising investors to conduct independent research and required analyst firms to disclose their distribution of recommendations in order to alert investors to potential bias in analysts’ recommendations.

We conduct three experiments to investigate whether and why investors rely on analysts’ recommendations, and how to mitigate overreliance on these recommendations. In Experiments 1 and 2, holding all other information constant, investors who receive a buy (sell) recommendation judge a company to have higher (lower) investment potential, indicating that regulators’ concerns are justified.

Further, explicitly warning participants about bias in recommendations and requiring them to form independent recommendations successfully reduce a buy (but not a sell) recommendation’s effect on investment judgments. However, Experiment 3 indicates that showing investors an analyst firm’s recommendation distribution that is skewed toward buys does not reduce a buy recommendation’s effects. Having a distribution is effective only when accompanied by either an explicit warning about possible bias in overly-skewed distributions, or a warning plus a requirement to form an independent recommendation. Our results suggest that current regulations about distribution disclosures may not sufficiently mitigate investors’ overreliance on analysts’ optimistic recommendations, and that more explicit warnings are required. Lastly, we find that the mitigating mechanisms work by tempering participants’ beliefs about the analyst’s ability to generate trading interest, expertise in evaluating information, and access to information.

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