Security analysts’ incentive and cognitive processing bias: evidence from analysts’ recommendations

Abstract

This study examines how incentive- and behavior-based variables affect analyst recommendation revisions. We use duration analysis to test analysts’ underreaction to information by isolating the effects of incentives and cognitive processing biases on the timing of recommendation revisions. By controlling for favorable (unfavorable) preceding recommendations, we find that analysts delay conveying bad (good) news, which is consistent with the predictions of both the incentives and cognitive dissonance hypotheses (only the cognitive dissonance hypothesis). We also find that analysts delay responses to favorable information for outperformers with lower representative information, suggesting that analysts’ underreaction to new favorable information is partially explained by the effect of psychological conservatism. Our results are robust after taking into account analyst affiliations, NASD Rule 2711 and SEC Rule 472, and market conditions.

Keywords:

• analyst recommendation
• cognitive processing bias
• cognitive dissonance
• incentive
• psychological conservatism

JEL Classifications:

• G14
• M41

Acknowledgements

The authors gratefully acknowledge the financial support of National Science Council (NSC 98-2410-H-155-013), National Taiwan University, and Yuan Ze University. We are grateful to First Call for the use of recommendation data. We have benefited from the helpful comments and suggestions made by an anonymous referee, Jenni Bettman, Pawel Bilinski, Howard Chan, Yuanchen Chang, Kevin Chen, Jia-Chi Cheng, Chen Lung Chin, Robin Chou, David Ding, Michael Eames, Hong Hwang (the Editor), Patricia O’Brien, Chris Pantzalis, Eben van Wyk, and seminar participants at Chung Yuan Christian University, Fu Jen Catholic university, National Chi Nan University, National Taiwan University, Yuan-Ze University, 2009 FMA annual meeting, 2010 FMA European conference, 2010 MFA annual meeting, and 2011 SFM conference. All remaining errors are our own.

Notes

1. See Stickel (1995), Womack (1996), Barber et al. (2001, 2003, 2006), Hope (2003), Jegadeesh et al. (2004), Ramnath, Rock, Shane (2008), and Moshirian et al. (2009) for examples.

2. Related literature also shows that analysts issue imperfect and, on average, overly optimistic earnings forecasts (e.g. Lys and Sohn 1990; Mendenhall 1991; Brown 1993; Dugar and Nathan 1995; Das, Levine, and Sivaramakrishnan 1998).

3. NASD proposed Rule 2711, Research Analysts and Research Reports, on 7 February, 2002, which was approved by SEC on May 8, 2002, with an effective date for implementing the provisions of no later than 9 September 2002. A related provision of NASD 2711 also requires that all brokerage firms must disclose definitions for buy, hold, and sell in their reports. The modified NYSE Rule 472 has an identical reporting requirement for NASD 2711.

4. Some studies suggest that forecast bias results from a cognitive-based perspective. See Kothari (2001) for a review.

5. We also conduct tests with the unfavorable category consisting of only sell and strong sell recommendations. The third hypothesis test does not provide meaningful results due to the small sample size. The other robustness test results do not qualitatively change the conclusion of our paper. All untabulated results are available on request.

6. We appreciate that the reviewer proposes that the conservatism group consist of underperformers with prior recommendation reversals of unfavorable recommendations to favorable ones.

7. McNichols and O’Brien (1997) suggest that analysts are prone to drop coverage when faced with unexpected bad earnings news rather than issuing negative recommendations.

8. Barber et al. (2006) restrict their recommendation observations to less than 12 months under the assumption that such a recommendation has become stale. We follow their assumption and the untabulated results are robust to the inclusion of observations with duration between the preceding and current recommendations of less than 1 year. We also repeat the analysis but exclude observations with duration between the preceding and current recommendations exceeding 2 years and obtain a similar result. We treat durations of two successive recommendations greater than 2 years as a presumed dropped coverage. Such exclusion trades off a decrease in the number of observations of less than 7% against an increase in the standard deviation of a duration of more than 60%.

9. The equality-of-variances test results suggest unequal variances for the unconditioned case, for which the folded F statistic is 1.04, with p = 0.0474. We thus use the Satterthwaite test to obtain t values assuming unequal variance.

10. The folded F statistic is 1.35, with p = <0.0001, suggesting that the hypothesis of equality of variances is not supported. Therefore, we use the Satterthwaite test to obtain t values assuming unequal variance.

11. To reduce the influence of analysts who drop coverage, we exclude observations with duration longer than 4 years between the second last prior recommendation and the current revision. We also exclude observations with duration longer than 18 months between the last recommendation and the current favorable revision in both the conservative and matching groups. We also conduct sensitivity tests with recommendations separated by less than 2 years and 3 years for conservatism and matching groups. We obtain similar findings in an untabulated test.

12. We use S&P500 returns as a benchmark and estimate the slope coefficients for the market model via (–120, 10) and (10, 120) windows to calculate abnormal returns.

13. We also exclude five-trading-day cumulative return and seven-trading-day cumulative return after unfavorable recommendations. The tenor of the results is unchanged.