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Are Investors Naive About Incentives?

62 Pages Posted: 18 Oct 2004 Last revised: 19 Jul 2010

Ulrike Malmendier

University of California, Berkeley - Department of Economics; University of California, Berkeley - Haas School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); Institute for the Study of Labor (IZA)

Devin M. Shanthikumar

University of California, Irvine - Paul Merage School of Business

Date Written: October 2004

Abstract

Traditional economic analysis of markets with asymmetric information assumes that uninformed agents account for the incentives of informed agents to distort information. We analyze whether investors in the stock market internalize such incentives. Stock recommendations of security analysts are likely to be biased upwards, particularly if the issuing analyst is affiliated with the underwriter of the recommended stock. Using the NYSE Trades and Quotations database, we find that large (institutional) traders account for the upward bias and exert no abnormal trade reaction to buy recommendations, and significant selling pressure in response to hold recommendations. Small (individual) traders do not account for the upward shift and exert significantly positive pressure for buys and zero pressure for hold recommendations. Moreover, large traders discount positive recommendations from affiliated analysts more than from unaffiliated analysts, while small traders do not distinguish between them. The naive trading behavior of small investors induces negative abnormal portfolio returns.

Suggested Citation

Malmendier, Ulrike and Shanthikumar, Devin M., Are Investors Naive About Incentives? (October 2004). NBER Working Paper No. w10812. Available at SSRN: https://ssrn.com/abstract=601114

Ulrike Malmendier (Contact Author)

University of California, Berkeley - Department of Economics ( email )

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Berkeley, CA 94720-3880
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HOME PAGE: http://www.econ.berkeley.edu/~ulrike/

University of California, Berkeley - Haas School of Business ( email )

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National Bureau of Economic Research (NBER)

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Centre for Economic Policy Research (CEPR)

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Institute for the Study of Labor (IZA)

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Devin Shanthikumar

University of California, Irvine - Paul Merage School of Business ( email )

Paul Merage School of Business
SB 440
Irvine, CA 92697-3125
United States

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