ARE SMALL INVESTORS NAÏVE?

 

This article seeks to answer the question whether significant differences exist in the reaction of large and small investors to market information as expounded by analysts, who may or may not be affiliated to the company whose stock is being reviewed. In doing this, we consider separately the trading behavior of large and small investors. Large traders are likely to be institutional investors, such as pension funds; small traders are more likely to be individual investors or small uninformed investment groups.

 

Stock analysis is a staple of the financial pages of newspapers, magazines and websites. Analysts often advice investors to buy, sell or hold on to securities issued by the company being reviewed and several retail investors have been known to rely on the information dispensed by these stock analysts in making their investment decisions. Sell-side analysts face a well-known conflict of interest when providing investment advice. On the one hand, reliable recommendations attract customers and enhance the analyst’s reputation. On the other hand, buy recommendations are more likely to generate trading business than sell recommendations, given short-selling constraints. Moreover, management tends to complain about low ratings and to “freeze out” the issuing analysts, and buy-side clients push for positive recommendations on stocks that they hold.

Future underwriters might issue higher recommendations to gain business, to increase future offer prices. For bond underwriters, positive coverage could be part of an implicit agreement with the issuer, as it is for equity issues. Directly or indirectly, analyst compensation depends on the “support” in generating corporate finance profits

 

A large body of research reveals that analysts often distort information for the benefit of their investment banking business. Several papers document that the recommendations of affiliated analysts are more favorable than those of unaffiliated analysts (We classify analysts as “affiliated” if they belong to a bank that has an underwriting relationship with the firms they are reporting on.). We also consider separately independent brokerage firms, which do not underwrite any securities and whose recommendations are more likely to be objective.

 

Research reveals that small investors take recommendations literally. Small investors also fail to account for the additional distortion due to underwriter affiliation. Potential explanations are higher costs of information and naiveté about distortions in analyst recommendations. These findings suggest that small investors are naive about the distortions and trust analysts too much. This implies the need to evolve independent and low cost means of gathering market information and analysis thereon. Such a development will mitigate the effect of analyst bias on investor bias.

 

Milton and Cross offers investment advisory and due diligence services to individual and corporate organizations engaging in share purchases as well as related transactions, thereby bridging information asymmetries and knowledge gaps in the market. We may be contacted directly on +2348036258312, or by email on : miltoncrosslexng@gmail.com.

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