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A Catering Theory of Analyst Bias

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  • Richard Kum-yew Lai

    (Harvard Business School)

Abstract

We posit a theory that runs counter to how conventional wisdom thinks about analyst bias, that it is the result of distorted incentives by “upstream” factors like the analysts’ employers. We suggest that analysts are also heavily influenced by the beliefs of investors downstream, the purported victims of analyst bias. We adapt Mullainathan-Shleifer’s theory of media bias to build a theory of how analysts cater to what investors believe. The theory also predicts that competition among analysts does not reduce their bias. We provide empirical support for this theory, using an enormous dataset built from over 6.5 million analyst estimates and 42.8 million observations on investor holdings, which we argue is a proxy for what investors’ beliefs. We use a simultaneous-equations model for estimation, with instruments to rule out alternative interpretations of the direction of causality. For additional robustness, we investigate the time series of analyst bias and heterogeneity in investor beliefs from 1987 through 2003. Dickey-Fuller tests show that both have unit roots, but we establish that cointegration holds. Further, we employ a vector- autoregressive model to show Granger-causality between the two.

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File URL: http://128.118.178.162/eps/fin/papers/0509/0509004.pdf
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Bibliographic Info

Paper provided by EconWPA in its series Finance with number 0509004.

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Length: 99 pages
Date of creation: 04 Sep 2005
Date of revision:
Handle: RePEc:wpa:wuwpfi:0509004

Note: Type of Document - pdf; pages: 99
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Web page: http://128.118.178.162

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Keywords: Analyst bias; behavioral finance; media bias;

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  1. Brown, Lawrence D & Rozeff, Michael S, 1978. "The Superiority of Analyst Forecasts as Measures of Expectations: Evidence from Earnings," Journal of Finance, American Finance Association, vol. 33(1), pages 1-16, March.
  2. Harrison Hong & Jeffrey D. Kubik, 2003. "Analyzing the Analysts: Career Concerns and Biased Earnings Forecasts," Journal of Finance, American Finance Association, vol. 58(1), pages 313-351, 02.
  3. Andrei Shleifer & Robert W. Vishny, 2001. "Stock Market Driven Acquisitions," NBER Working Papers 8439, National Bureau of Economic Research, Inc.
  4. Jeffrey A. Wurgler & Malcolm P. Baker, 2001. "Market Timing and Capital Structure," Yale School of Management Working Papers ysm181, Yale School of Management.
  5. Malcolm Baker & Jeffrey Wurgler, 2003. "A Catering Theory of Dividends," NBER Working Papers 9542, National Bureau of Economic Research, Inc.
  6. Mastrapasqua, Frank & Bolten, Steven, 1973. "A Note on Financial Analyst Evaluation," Journal of Finance, American Finance Association, vol. 28(3), pages 707-12, June.
  7. Daniel Kahneman, 2003. "A Psychological Perspective on Economics," American Economic Review, American Economic Association, vol. 93(2), pages 162-168, May.
  8. Grinblatt, Mark & Titman, Sheridan & Wermers, Russ, 1995. "Momentum Investment Strategies, Portfolio Performance, and Herding: A Study of Mutual Fund Behavior," American Economic Review, American Economic Association, vol. 85(5), pages 1088-1105, December.
  9. Sendhil Mullainathan & Andrei Shleifer, 2002. "Media Bias," Harvard Institute of Economic Research Working Papers 1981, Harvard - Institute of Economic Research.
  10. Karl B. Diether & Christopher J. Malloy & Anna Scherbina, 2002. "Differences of Opinion and the Cross Section of Stock Returns," Journal of Finance, American Finance Association, vol. 57(5), pages 2113-2141, October.
  11. John R. Graham, 1999. "Herding among Investment Newsletters: Theory and Evidence," Journal of Finance, American Finance Association, vol. 54(1), pages 237-268, 02.
  12. Sendhil Mullainathan & Andrei Shleifer, 2005. "The Market for News," American Economic Review, American Economic Association, vol. 95(4), pages 1031-1053, September.
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