Analysts' Incentives and the Dispersion Effect

Abstract:     
In this paper, we explain the negative relationship between analysts' forecast dispersion and future stock return, commonly known as the dispersion effect, as a result of analysts' incentives of not fully downward revising their earnings forecasts when they possess bad news about the firms they cover. Consistent with this conjecture, we find (1) that analysts' incentives simultaneously increase dispersion and induce an upward bias in reported consensus forecasts,(2) that the dispersion effect only exists among firms with bad future earnings, (3) that the dispersion effect disappears once we control for the incentive-induced upward bias in the reported consensus forecast, and (4) that the dispersion effect is stronger among firms with lower information uncertainty. The last two findings offer support unique to our analysts' incentives-based explanation of the dispersion effect.

Number of Pages in PDF File: 36

Keywords: Analysts' incentives, Dispersion effect

JEL Classification: G14

working papers series