Competition and Opportunistic Advice of Financial Analysts: Theory and Evidence

Abstract

This work investigates whether competition helps mitigating biases in recommendations issued by affiliated analysts. Competition is measured as the strength of coverage of a stock from unaffiliated analysts. A theoretical model is developed to show how the interaction of competition and reputational incentives induces affiliated analysts to report less optimistic recommendations when unaffiliated analysts issue a recommendation on the same stock. This empirical prediction finds confirmation when tested on data about IPO recommendations. The data also show that the effect of competition is weaker when conflicts of interests are stronger. A similar empirical behaviour could be observed if affiliated analysts were affected by psychological biases. This hypothesis does not find confirmation in the data. The evidence provided in this paper suggests that affiliated analysts overoptimism is induced by incentives rather than by a psychological bias.