Naive Small Investors

The August Journal of Financial Economics reports that large traders tend to compensate for the fact that "security analysts tend to bias stock recommendations upward, particularly if [the analyst is] affiliated with the underwriter."   But "small traders, instead, follow recommendations literally.

So to help you small investors, I’ve made a handy guide.  If the analyst is not affiliated with those pushing the stock:

  • When the analyst says "strong buy", you should buy.
  • When the analyst says "buy", you should hold.
  • When the analyst says "hold", you should sell.

If the analyst is affiliated with those pushing the stock:

  • When the analyst says "strong buy", you should hold.
  • When the analyst says "buy", you should sell.
  • When the analyst says "hold", oh my God, sell!!!
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  • http://bizop.ca michael webster

    What about when the CEO of a bank runs around saying “no panic, no panic”? Bank run or no bank run?

  • http://www.ProductivityShock.com Jason Briggeman

    With transactions costs as low as they are nowadays, it seems there should only be “hold” and “don’t hold” recommendations…for what important distinction is there between “buy” and “hold”? A $5 commission?

  • http://profile.typekey.com/sentience/ Eliezer Yudkowsky

    Shouldn’t the actual recommendation be “ignore analysts, you could do better with a dartboard”?

  • http://cob.jmu.edu/rosserjb Barkley Rosser

    Robin,

    Are you ruling out the contratian strategy? If they say buy, you sell. If they say sell, you buy.
    I guess if they say hold, well, I don’t know about that one.

    Remember Lord Rothschild. When blood is flowing in the streets, it is the time to buy.

  • Dan Riley

    I am skeptical that contrarianism is, by itself, a viable strategy. It works sometimes because the recommendations of analysts are frequently (but not always) lagging indicators. Successful contrarian investing requires some ability to distinguish between “everyone should sell this now” and “I should have sold this months ago”.

  • Shakespeare’s Fool

    Because I’ve read “A Random Walk Down Wall Street”
    by Burton Malkiel and similar books, I am skeptical
    of any market forecasts, and of stock pickers.

    The research those writers refer to shows stock
    picking to be a nearly impossible task. (And
    shows that many of us are seduced into accepting
    advice by brief records of success which Malkiel and
    others believe are mostly strings of luck.
    They believe successful stock pickers are like
    coin flippers – for every thousand people who
    flip a coin ten times you would expect 1 to get
    10 heads – and the people who follow the
    recommendations of stock pickers are following
    people who no more skillful than the lucky people
    who flipped 7 or 8 or 9 or 10 heads in a row.

    But perhaps I believe this because, when it comes
    to stock picking, I have rarely gotten even one
    head in a row.

    Maybe the world of stock pickers and their
    followers are right and I am defective.

    John

    http://books.google.com/books?id=Avu090CNzb8C

  • K

    I endorse what Shakes Fool said. A Random Walk is well worth reading.

    Down grades deserve your attention. Upgrades mean little.

    Truly bad investments can often be identified and losses avoided or stopped promptly. But the truly superior buys are nearly impossible to find in an orderly market.

    Those generating market advice don’t have to be right. They have to be convincing.

  • ed

    I have better advice:

    * When the analyst says “strong buy”, you should make regular investments in an index fund.
    * When the analyst says “buy”, you should make regular investments in an index fund.
    * When the analyst says “hold”, you should make regular investments in an index fund.

  • J Thomas

    * When the analyst says “**”, you should make regular investments in an index fund.

    But which analysts do you depend on when you choose which index fund?