The University Record, April 1, 2002

Wall Street analysts make herd decisions

By Bernard DeGroat
News and Information Services

Wall Street has always had bears and bulls, but when it comes to stock analysts, in particular, it also has a fair number of sheep, according to a U-M Business School researcher.

In a new study published in the current issue of Administrative Science Quarterly, Business School Prof. Gerald F. Davis, along with Hayagreeva Rao of Emory University and Henrich R. Greve of the Norwegian School of Management, found that equity analysts at investment banks “follow the herd” when deciding to initiate coverage of a firm and in making recommendations whether to buy, hold or sell a security.

In fact, each member of a “herd” who adds coverage of a firm, roughly triples the likelihood that other analysts will add the company to their coverage the next year, according to the study.

“Analysts’ coverage choices are consequential, visible and subject to considerable uncertainty,” Davis says. “Social proof—using the actions of others to infer the value of a course of action—goes a long way toward reducing that uncertainty.”

The researchers, who studied analyst coverage of more than 2,000 Nasdaq firms in 1987–1994, say that much like other decisions people make, analysts tend to look at what their peers are doing before deciding what to do.

“It’s sort of like when you see a crowd lining up outside a restaurant, you’re more likely to go there than to a restaurant that’s half-empty,” Davis says. “This is something that we all believe to be true about non-economic situations, such as when deciding what restaurant to eat at. But we found that analysts do the same thing. When a lot of other analysts start following a firm, more analysts are likely to jump in.”

Aside from a lack of independent decision-making, the danger in “following the crowd” is that analysts are more likely to overestimate a company’s profitability (future earnings), Davis and colleagues say.

The study shows that analysts who add a firm after following a herd of at least 10 other analysts are more than three times as likely to overestimate the firm’s earnings than analysts who do not follow a herd.

Analysts, the researchers add, prefer to follow firms that do well or are expected to do well (less than 5 percent of analysts’ recommendations are to sell, rather than to buy or hold), but by doing so, are more likely to overrate a company’s stock.

“Those that follow the herd are more likely to be wrong, more likely to be disappointed, and more likely to quit later,” Davis says. “You might imagine that if it’s all about following the herd, then one company would get all of the analysts. But we don’t find that. We find that when a company gets a lot of analysts, they show up at the restaurant, they realize the food is bad and they don’t come back.”

The researchers say that while social proof plays a large role among analysts in initiating coverage of a firm, this is not the case in deciding to abandon coverage.

“Social proof is a double-edged sword,” Rao says. “It is easy for decision-makers to use, but precisely because it is easy to use, it leads to errors and decision reversals. However, once analysts have adopted [a firm] and can make direct evaluations, they do not use external cues to make choices about abandonment. They discover and correct mistakes.”

Nonetheless, securities analysts are no different than anyone else when it comes to the dynamics of social influence in decision-making, the study shows.

“Overall, our message isn’t really so much about whether people should be trusting analysts as much as it is about understanding that they’re just like the rest of us,” Greve says. “They’re trend-followers.”