Investors’ Reliance on Analysts’ Stock Recommendations and Mitigating Mechanisms for Potential Overreliance

Posted: 13 Sep 2012

See all articles by Khim Kelly

Khim Kelly

University of Central Florida

Bernardine M. Low

Nanyang Technological University (NTU)

Hun-Tong Tan

Nanyang Business School, Nanyang Technological University

Seet-Koh Tan

Nanyang Technological University (NTU) - Division of Accounting

Multiple version iconThere are 2 versions of this paper

Date Written: September 1, 2012

Abstract

Regulators express concerns with investors’ unquestioning reliance on analysts’ recommendations, which prior research has shown to be associated with lower trading returns. Thus, regulators have published investor guides advising investors to conduct independent research and required analyst firms to disclose their distribution of recommendations in order to alert investors to potential bias in analysts’ recommendations. We conduct three experiments to investigate whether and why investors rely on analysts’ recommendations, and how to mitigate overreliance on these recommendations. In Experiments 1 and 2, holding all other information constant, investors who receive a buy (sell) recommendation judge a company to have higher (lower) investment potential, indicating that regulators’ concerns are justified. Further, explicitly warning participants about bias in recommendations and requiring them to form independent recommendations successfully reduce a buy (but not a sell) recommendation’s effect on investment judgments. However, Experiment 3 indicates that showing investors an analyst firm’s recommendation distribution that is skewed toward buys does not reduce a buy recommendation’s effects. Having a distribution is effective only when accompanied by either an explicit warning about possible bias in overly-skewed distributions, or a warning plus a requirement to form an independent recommendation. Our results suggest that current regulations about distribution disclosures may not sufficiently mitigate investors’ overreliance on analysts’ optimistic recommendations, and that more explicit warnings are required. Lastly, we find that the mitigating mechanisms work by tempering participants’ beliefs about the analyst’s ability to generate trading interest, expertise in evaluating information, and access to information.

Keywords: Stock recommendations, Analyst bias, Analyst disclosures, NASD Rule 2711

JEL Classification: C91, G18, M41

Suggested Citation

Kelly, Khim and Low, Bernardine M. and Tan, Hun-Tong and Tan, Seet-Koh, Investors’ Reliance on Analysts’ Stock Recommendations and Mitigating Mechanisms for Potential Overreliance (September 1, 2012). Contemporary Accounting Research, Vol. 29, No. 3, 2012, Available at SSRN: https://ssrn.com/abstract=2146294

Khim Kelly

University of Central Florida ( email )

12744 Pegaus Dr
Orlando, FL 32816
United States

Bernardine M. Low

Nanyang Technological University (NTU) ( email )

S3 B2-A28 Nanyang Avenue
Singapore, 639798
Singapore

Hun-Tong Tan

Nanyang Business School, Nanyang Technological University ( email )

Singapore, 639798
Singapore
+65 6790 4819 (Phone)
+65 6793 7956 (Fax)

Seet-Koh Tan (Contact Author)

Nanyang Technological University (NTU) - Division of Accounting ( email )

Singapore, 639798
Singapore

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Abstract Views
1,280
PlumX Metrics