Effects of Behavioral Factors on Analyst Forecasts

An analyst’s job is to keenly study the firms under their charge to make appropriate recommendations. Often, analysts are considered experts on a particular industry or group of companies. Since their relationships with the market are unique, it stands to reason analysts are affected by different biases. Below are some major biases often associated with analysts and their forecasts.

Overconfidence

Overconfidence is the most prominent bias analysts display. This is often brought about by the fact that analysts have:

• Large amounts of available data.
• Access to company management.
• Sophisticated forecasting tools.
• Industry experience.

All these attributes inform management’s decisions on the firms and securities they follow. Nevertheless, none of these facts alone guarantees the accuracy of the analysts’ forecasts and opinions. It is recommended that analysts seek contradictory opinions and update their forecasts with Bayesian methods to avoid being overconfident.

Remedial Actions for Overconfidence Bias

• Use the Bayes probability formula.
• Consider the sample size.
• Document comparable data.
• Get well-structured and accurate feedback.
• Come up with a structure that rewards accuracy.
• Make forecasts that are unambiguous.
• Carry out regular appraisals.

Influence by Management

This area of concern involves potential biases, which often start from company management and affect how companies report results. The following four biases are prevalent in this scenario.

1. Framing: Refers to the tendency to absorb and process the same information differently due to format or presentation variations. This could be as subtle as listing accomplishments first in order to make a report sound positive.
2. Anchoring and adjustment bias: This bias affects analysts since they often become attached to previous forecasts or recommendations. Consequently, they may have trouble updating them appropriately as new data emerge.
3. Availability: This bias states that more readily available and obvious information is given precedence over other equally important information that may be harder to obtain or notice. This means an ambitious report from company management may unduly influence analysts. This bias is premised upon the fact that more emotional information tends to be easier to recall.
4. Self-attribution: Management is often compensated on company financial metrics such as stock price or earnings per share. For this reason, management is generally inclined to present results in a way that boosts their compensation.

Remedial Actions for Influence of Company’s Management on Analysis

• Ensuring a disciplined and systematic approach when interpreting company information.
• Focusing on comparable data that is quantitative and verifiable.
• Properly calibrating data by gathering information and identifying suitable underlying base rates.

Biases in Research

• Confirmation bias: This bias occurs when an analyst seeks to provide credence to previously released forecasts and opinions rather than seeking contradictory information. This natural human tendency helps resolve cognitive dissonance.
• Gambler’s fallacy: Refers to incorrectly predicting a reversal to the mean.

Remedial Action for Analyst Biases

• Pay more attention to objective data, e.g., Trailing earnings.
• Evaluate previous forecast bearing anchoring and adjustment in mind.
• Collect information systematically. 
• Assign probabilities to underlying base rates.
• Use a structured process to gather and process information.

Question

Tim and his college roommate have been enthralled by a closely competitive NCAA march madness finals game. Their favorite player has been on a streak and seems incapable of missing a shot. Tim exclaims, “Please give him the ball. This guy has a hot hand; he can’t miss!” The roommate rebuffs with, “He is well over his season’s average shot percentage and is due for a miss.” This is most likely a representation of?

1. Anchoring and adjustment bias.
2. Framing bias.
3. Gambler’s fallacy.

Solution

The correct answer is C:

Tim has predicted that the player will continue making all his shots, while the roommate believes he must shoot off-target soon. Under probability theory, each time a player takes a shot, it is an independent event, and the chances of a make are just the average shot percentage over the season or career, not the average shot percentage adjusted for a streak or lack of streak.

A is incorrect: This bias involves anchoring on a number.

B is incorrect: Framing bias involves absorbing information differently, depending on how it is presented.

Reading 2: Behavioral Finance and Investment Processes

Los 2 (e) Discuss how behavioral factors affect analyst forecasts and recommend remedial actions for analyst biases