Are Investors Naive About Incentives?

Abstract

Traditional economic analysis of markets with asymmetric information assumes that the uninformed agents account for the incentives of the informed agents to distort information. We analyze whether investors in the stock market internalize such incentives in practice. Security analysts provide investors with information about investment opportunities by issuing buy and sell recommendations. These recommendations are likely to be biased upwards, particularly if the issuing analyst is affiliated with an investment bank that is a recent underwriter of the recommended firm. Using the trading data from the New York Stock Exchange Trades and Quotations database (TAQ), we find that large (institutional) investors generate abnormal volumes of buyer-initiated trades after a positive recommendation only if the analyst is unaffiliated. Small (individual) traders exert abnormal buy pressure after all positive recommendations, whether the analyst is affiliated or unaffiliated. Large traders also exert significant selling pressure in response to hold recommendations, and no pressure in response to buy recommendations while small traders exert zero pressure for hold recommendations and significantly positive pressure for buys. The trading behavior of small investors induces losses relative to large investor trading behavior, since stocks recommended by affiliated analysts perform significantly worse than those recommended by unaffiliated analysts. Our results imply that larger investors account for the incentives of analysts to distort information, but small investors do not. Increased coverage of a stock does not reduce the informational distortion of affiliated analysts.