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Analysts Are Victims of Behavioral Biases, Too

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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.

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“If we were to look at all the variables that would affect future profits, there would actually be thousands, and we think it’s pretty close to impossible to take them all into account,” he said. “And yet analysts get paid large sums to make the forecasts that investors eagerly wait for. What we have learned from the field of behavioral psychology is that those who make forecasts rely more on things that are easily observable and that make them feel good, for lack of a better term, about their forecast. As such, we think there is a strong reason why analysts are biased in their behavior and that behavior is predictable.”

BRC bases its investment strategies on that hypothesis and has built a proprietary model that allows BRC to analyze the behavioral biases of analysts and find investment opportunities where analysts are making systematic errors in their earnings forecasts. The model was built to anticipate security analyst behavior, predict earnings surprises and assess valuation, and it ranks all stocks in an investible universe on a daily basis. These rankings correspond to the greater or lesser likelihood of a particular company announcing a positive earnings surprise or receiving a positive analyst revision — events that are often associated with excess stock returns.

“We start with individual analysts at the name level and every day, we analyze every single forecast they make for every stock they follow, ” Riddle says. “This is our raw data and we look at the relationships between the individual analyst and the group of analysts following a particular stock.”

The BRC investment strategies are driven by this behavioral model. The portfolios are constructed from those securities that are ranked in the top 10% of the quantitative behavioral model. Highly ranked securities are further evaluated by our team of analysts who look for persistence in the driving factors influencing the behavior we have identified. A stringent risk management process results in stable sector and style exposures and a realized beta significantly lower than the market.

“We have done a lot of research and we think that having a high exposure to [analyst behavior] is an effective way to manage our portfolios,” Riddle said. “There are many people that think there is a sub-group of very smart and influential analysts that are able to consistently produce more accurate estimates than their peers. That would be very important information to us if it were true, but we can’t find evidence that these super-analysts exist.”