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Are Investors Naive About Incentives?

  • Ulrike Malmendier
  • Devin Shanthikumar

Traditional economic analysis of markets with asymmetric information assumes that uninformed agents account for the incentives of informed agents to distort information. We analyze whether investors in the stock market internalize such incentives. Stock recommendations of security analysts are likely to be biased upwards, particularly if the issuing analyst is affiliated with the underwriter of the recommended stock. Using the NYSE Trades and Quotations database, we find that large (institutional) traders account for the upward bias and exert no abnormal trade reaction to buy recommendations, and significant selling pressure in response to hold recommendations. Small (individual) traders do not account for the upward shift and exert significantly positive pressure for buys and zero pressure for hold recommendations. Moreover, large traders discount positive recommendations from affiliated analysts more than from unaffiliated analysts, while small traders do not distinguish between them. The naive trading behavior of small investors induces negative abnormal portfolio returns.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10812.

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Date of creation: Oct 2004
Date of revision:
Publication status: published as Malmendier, Ulrike and Devin Shanthikumar. "Are Small Investors Naïve About Incentives?" Journal of Financial Economics 85, 2 (August 2007): 457-489.
Handle: RePEc:nbr:nberwo:10812
Note: AP
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