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

Abstract

We conduct three experiments to investigate whether and why investors rely on analysts’ stock recommendations, and how to mitigate potential overreliance. In Experiments 1 and 2, we find that investors who receive a buy (sell) recommendation judge a company to have higher (lower) investment potential, holding all other information constant. Warning investors about potential bias in recommendations and requiring them to form an independent stock recommendation reduce a buy recommendation’s effect on investors’ judgments, but do not reduce a sell recommendation’s effect on investors’ judgments. In Experiment 3, we find that merely disclosing the analyst firm’s distribution of stock recommendations as per current FINRA/NYSE stock exchange rules does not reduce the effects of a buy recommendation associated with a distribution skewed toward buys, unless accompanied by a warning about potential bias in overly-skewed distributions or a warning plus a requirement to form an independent recommendation. Lastly, investors indicate that they rely on analysts’ recommendations based on beliefs about the analyst’s ability to generate trading interest, expertise in evaluating information, and access to information. Warning about analyst bias plus inducing independent judgment temper those beliefs, and those beliefs mediate the effects of warning and independent judgment on investors’ judgments.