Are analysts biased? An analysis of analysts' stock recommendations that perform contrary to expectations

Abstract

This paper seeks to test whether analysts are prone to behavioral biases when making stock recommendations. In particular, we work with stocks whose performance subsequent to a new buy or sell recommendation is in the opposite direction to the recommendation. We find that these “nonconforming” recommendations are associated with overconfidence bias (as measured by optimism in the language analysts use), representativeness bias (as measured by previous stock price performance, market capitalization, and book-to-market), and potential conflicts of interest (as measured by investment banking relationships). Our results demonstrate that potential conflicts of interest significantly predict analyst nonconforming stock recommendations. This supports recent policy-makers’ and investors’ allegations that analysts’ recommendations are driven by the incentives they derive from investment banking deals. These allegations have led to implementation of rules governing analyst and brokerage house behavior. However, our finding that psychological biases also play a major role in the type of recommendation issued suggests that these rules may work only in as far as regulating conflicts of interest, but will have a limited role in regulating the cognitive biases to which analysts appear to be prone. Our results suggest that, as a result of this, analyst stock recommendations are likely to continue to lack investment value.