When Security Analysts Talk, Who Really Listens?
Skip to content
Aug 1, 2010

When Security Analysts Talk, Who Really Listens?

Large and small investors find different results when following analyst recommendations

Based on the research of

Michael B. Mikhail

Beverly Walther

Richard H. Willis

When it comes to investing, it seems like a good idea to follow experts’ recommendations. Real-world results generally support that intuition. However not all recommendations are equally profitable, and when deciding how to act, individual investors should take a second look at both the analyst reports and the circumstances under which the analysts operate.

Small investors reacting to a sell-side security analyst’s recommendations lose an average of nearly two percent on their trading activities in the five days after the recommendation is issued, according to research by Beverly Walther, a professor of Accounting and Information Management at the Kellogg School of Management. In contrast, large traders reacting to the same advice gain more than five percent in the same time period. Walther says it appears that small investors react to the mere issuance of recommendations, without looking at the underlying arguments in the report, assessing the credibility of the information, or considering analysts’ competing interests.

An analyst may have the incentive to issue a biased, overly optimistic report if he or she works at an investment banking house or a company that has done investment banking deals with the firm under review, Walther points out. Even analysts who do not have these relationships may have an incentive to be overly optimistic because they sometimes rely on firm management to try to get inside information and do not want to alienate the firm’s management.

To protect investors, in 2003 the Securities and Exchange Commission adopted Regulation AC. It requires stock analysts and others that issue a report on a security to certify that the views expressed are accurate reflections of their personal views. They must also disclose whether they were compensated for the views expressed.

Walther notes that despite the concerns expressed by regulators, “it’s not really clear that small investors—individuals—rely that much on analyst reports to begin with and, if they do react, that they are harmed.” Working with Michael B. Mikhail of Arizona State University and Richard H. Willis of Vanderbilt University, Walther evaluated how small and large investors respond to security analyst stock recommendations and how their returns compare.

The researchers categorized investors based on the amounts of their trades: “large” was defined as more than $30,000, and “small” was defined as less than $7,000. Walther explains that, in general, the size of the trade indicates the type of trader. “If they’re placing trades of $50,000 or $200,000 at a time, presumably those are fundamentally different types of entities than ones placing a trade of $1,000,” she says. “But the data available do not allow us to definitively classify the trades we see as being placed by institutions or individuals.”

Large Investors Look More Carefully at the Information
Walther and her colleagues used the Zacks Investment Research database to obtain the dates and values of recommendations issued by individual analysts during 1993 to 1999, prior to the implementation of Regulation AC. “If you look at one of these analyst reports on a firm, you’ll see there’s a lot of ‘headline’ information that the media very often pulls out,” Walther says. “The analyst will say, for example, that they are issuing a buy recommendation. They give an earnings forecast or report what they expect the price to be sometime in the future for this firm.”

But Walther cautions that “more often than not, following that headline is a discussion the analyst writes, essentially justifying the recommendation.” The analyst’s report often contains information such as “what the analyst expects the demand for the firm’s products to be, industry trends, future expenses—much more detailed information that they use to come up with that summary recommendation.”

After developing measures of how much information was in each report, the researchers found that large traders’ reactions were associated with how much information was available. “If there was a lot more information in the report, large traders traded more. If there was not as much information in the report, large traders traded less,” Walther summarizes. Small investors seemed to react to the occurrence of a recommendation rather than to the information contained in the more detailed report.

Thus, both large and small investors reacted to recommendation revisions, but their reactions differed. “While large investors trade more in response to the information conveyed by the analyst’s recommendation and earnings forecast revision, small investors trade more in response to the occurrence of a recommendation,” the researchers write in a paper based on their research.

The article also reports that small investors traded more than large investors following upgrade and buy recommendations, and they traded more following upgrade and buy recommendations than they did following downgrade and hold/sell recommendations. The researchers cite evidence that the market reaction to upgrades/buy recommendations is typically less pronounced than the reaction to downgrade/sell recommendations, and they argue that as a result, upgrade/buy recommendations are less credible than downgrade or hold/sell recommendations. It seems that small investors do not take this into consideration when reacting to analysts’ recommendations.

Large Traders Earn More than Small Traders
Surprisingly, small traders tended to be net purchasers following recommendation revisions, regardless of the direction of the recommendation revision. Conversely, large traders tended to be net sellers following downgrades and sells. As a consequence of the differences in trading patterns, small traders tend to lose money and large traders tend to make money. This finding provides some support for regulators’ concerns that analysts may easily mislead small investors, Walther and her colleagues conclude in their paper.

The researchers’ analysis shows that large traders tended to make money regardless of the type of recommendation. Conversely, small traders lost money overall, as well as after downgrades and sells. Large traders earned an average of 5.1 percent compared with a 0.9 percent loss for small traders following strong buys/buys. The difference was even larger for the trading period following hold/sell recommendations, when large traders earned 5.2 percent and small traders lost 3.1 percent.

Figure 1. Estimates of how much money was made or lost by large and small investors in the five trading days following the issuance of a recommendation.

In addition, even though small traders bought more than large traders did following upgrade and strong buy/buy recommendations, small traders made less money from these trades. Large traders earned 5.4 percent following an upgrade recommendation, compared with earnings of 0.4 percent for small traders. “This finding is surprising given that returns surrounding these recommendations are, on average, positive,” the researchers write. “One possibility is that large traders are able to discern which recommendations are associated with more profitable returns while small traders are not.”

Walther and her colleagues conclude that their research “provides preliminary evidence supporting regulators’ concerns that small investors do not properly consider the effects of analyst incentives on report credibility when reacting to recommendations.” They note that because their analyses are based on analyst recommendations issued prior to the passage of Regulation AC, it “remains an open question whether these disclosures are effective in mitigating small investors’ apparently suboptimal investment decisions.”

About the Writer
Beverly A. Caley, JD, is a freelance writer based in Corvallis, Ore.
About the Research

Mikhail, Michael B., Beverly R. Walther, and Richard H. Willis. 2007. “When security analysts talk, who listens?” The Accounting Review, 82: 1227-1253.

Read the original

Most Popular This Week
  1. What Happens to Worker Productivity after a Minimum Wage Increase?
    A pay raise boosts productivity for some—but the impact on the bottom line is more complicated.
    employees unload pallets from a truck using hand carts
  2. How to Get the Ear of Your CEO—And What to Say When You Have It
    Every interaction with the top boss is an audition for senior leadership.
    employee presents to CEO in elevator
  3. 6 Takeaways on Inflation and the Economy Right Now
    Are we headed into a recession? Kellogg’s Sergio Rebelo breaks down the latest trends.
    inflatable dollar sign tied down with mountains in background
  4. Which Form of Government Is Best?
    Democracies may not outlast dictatorships, but they adapt better.
    Is democracy the best form of government?
  5. When Do Open Borders Make Economic Sense?
    A new study provides a window into the logic behind various immigration policies.
    How immigration affects the economy depends on taxation and worker skills.
  6. How Offering a Product for Free Can Backfire
    It seems counterintuitive, but there are times customers would rather pay a small amount than get something for free.
    people in grocery store aisle choosing cheap over free option of same product.
  7. How Has Marketing Changed over the Past Half-Century?
    Phil Kotler’s groundbreaking textbook came out 55 years ago. Sixteen editions later, he and coauthor Alexander Chernev discuss how big data, social media, and purpose-driven branding are moving the field forward.
    people in 1967 and 2022 react to advertising
  8. Why Do Some People Succeed after Failing, While Others Continue to Flounder?
    A new study dispels some of the mystery behind success after failure.
    Scientists build a staircase from paper
  9. How Much Do Boycotts Affect a Company’s Bottom Line?
    There’s often an opposing camp pushing for a “buycott” to support the company. New research shows which group has more sway.
    grocery store aisle where two groups of people protest. One group is boycotting, while the other is buycotting
  10. 5 Takeaways on the State of ESG Investing
    ESG investing is hot. But what does it actually deliver for society and for shareholders?
    watering can pouring over windmills
  11. How Are Black–White Biracial People Perceived in Terms of Race?
    Understanding the answer—and why black and white Americans may percieve biracial people differently—is increasingly important in a multiracial society.
    How are biracial people perceived in terms of race
  12. Could Bringing Your "Whole Self" to Work Curb Unethical Behavior?
    Organizations would be wise to help employees avoid compartmentalizing their personal and professional identities.
    A star employee brings her whole self to work.
  13. What Went Wrong at AIG?
    Unpacking the insurance giant's collapse during the 2008 financial crisis.
    What went wrong during the AIG financial crisis?
  14. Why Well-Meaning NGOs Sometimes Do More Harm than Good
    Studies of aid groups in Ghana and Uganda show why it’s so important to coordinate with local governments and institutions.
    To succeed, foreign aid and health programs need buy-in and coordination with local partners.
  15. 3 Tips for Reinventing Your Career After a Layoff
    It’s crucial to reassess what you want to be doing instead of jumping at the first opportunity.
    woman standing confidently
  16. Immigrants to the U.S. Create More Jobs than They Take
    A new study finds that immigrants are far more likely to found companies—both large and small—than native-born Americans.
    Immigrant CEO welcomes new hires
  17. Podcast: Does Your Life Reflect What You Value?
    On this episode of The Insightful Leader, a former CEO explains how to organize your life around what really matters—instead of trying to do it all.