Are Small Investors Naive About Incentives?

Malmendier, Ulrike; Shanthikumar, Devin M.

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Are Small Investors Naive About Incentives?

Journal of Financial Economics, Forthcoming

51 Pages Posted: 27 Mar 2007

See all articles by Ulrike Malmendier

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

Abstract

Security analysts tend to bias stock recommendations upward, particularly if they are affiliated with the underwriter. We analyze how investors account for such distortions. Using the NYSE Trades and Quotations database, we find that large traders adjust their trading response downward: they exert buy pressure following strong buy recommendations, no reaction to buy recommendations, and selling pressure following hold recommendations. This discounting is even more pronounced when the analyst has an underwriter affiliation. Small traders, instead, follow recommendations literally. They exert positive pressure following both buy and strong buy recommendations and zero pressure following hold recommendations. We discuss possible explanations for the differences in trading response, including information costs and investor naiveté.

Keywords: Stock recommendations, Trade reaction, Individual and institutional investors, Conflicts of interest, Behavioral finance

JEL Classification: G14, G25, G29, D82, D83

Suggested Citation: Suggested Citation

Malmendier, Ulrike and Shanthikumar, Devin M., Are Small Investors Naive About Incentives?. Journal of Financial Economics, Forthcoming, Available at SSRN: https://ssrn.com/abstract=975028