Investors dislike losses much more than they like gains; this is one of the core tenets of behavioral finance. According to BRC Investment Management LLC, it also applies to sell-side analysts working at Wall Street firms.
Just like the rest of us, analysts behave in a way that’s inconsistent with the workings of a completely efficient market, says John Riddle, managing principal and chief investment officer at BRC. Their thinking and actions are influenced by the same complex set of factors and biases that influence investors in their financial decision-making process, he said, including overconfidence, information “anchoring,” groupthink or “herding,” and risk aversion. Analysts are also keen to fit in with their peer group, as they “would rather be wrong in a group than occasionally right by themselves, even if that increases the risk of being occasionally wrong,” Riddle said. They’re concerned about their reputation, their compensation and they are subject to the pressure of maintaining relationships with company management teams. These are highly educated professionals and their behavior seems reasonable.
At the same time, though, investors closely monitor what analysts say, and their investment decisions are based in large part on analyst predictions about companies’ earnings estimates. In turn, security prices and investment returns are greatly influenced by changing investor expectations driven by analyst predictions.
“We have looked at hundreds of variables over the year and we can’t find anything that is more important than what security analysts say,” stated Riddle, who has been studying financial behavior since the 1970s. “The behavior of security analysts has a huge impact on people’s expectations. It influences their investment decisions and, we think, drives stock prices in the medium-term.”
Though investors place great significance in the earnings forecasts of analysts — in particular those who are highly reputable — it is actually inherently difficult to forecast future earnings and profits accurately, Riddle said.