We all know the impulse. When confronted with evidence that we are wrong — whether in a domestic or professional setting — our pride often compels us to dig in our heels and refuse to acknowledge the error. Sometimes, especially when our honor seems to be on the line, we even raise the stakes, as though a daring show of “certainty” could somehow prove our case.
Unfortunately, it appears that Wall Street stock analysts are disturbingly prone to this same, all-too-human tendency.
A new study entitled “Do Sell Side Stock Analysts Exhibit Escalation of Commitment?” analyzed some 6,200 analysts’ quarterly forecasts on about 3,500 companies over more than 18 years and found that these supposedly rational experts won’t admit when they’re wrong. The analysts “stubbornly stick” to lousy picks and “dig in their heels” instead of correcting a lousy call. “Escalation of Commitment” is the term the researchers apply to the statistical tendency of stock analysts to double down after the markets contradicts their stock predictions.
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It’s bad enough when a stock-picker won’t admit a boneheaded call. But Stanford researchers say the problem goes much deeper than that: A stubborn analyst can actually contribute to market bubbles and bust cycles. From the study:
Analysts who make “extreme” quarterly forecasts — above or below the consensus or median estimate among all analysts following a given stock — tend to dig in their heels after being proved wrong. Once a company reports quarterly earnings showing the analyst was too optimistic or too pessimistic, the extreme incorrect analyst will revise his or her full-year forecast, but will move less aggressively in the direction of the earnings surprise than other analysts. This stubbornness hurts an analyst’s overall forecasting accuracy.
Furthermore, lead researchers John Beshears, a finance professor at Stanford, and Katherine L. Milkman of the Wharton School at the University of Pennsylvania, say “escalation bias” hurts all investors.
The research has broader implications for understanding financial markets. Persistent, widespread over-optimism or over-pessimism by market participants could lead to mispricing of assets. For example, that stubbornness contributed to the financial crisis of 2007-2008. Despite initial signs of a weakening real estate market, many analysts, investors, and lenders maintained or stepped up their commitment to housing-related assets, such as mortgage-backed securities. The result: The housing bubble continued longer than it should have, delaying and exacerbating the subsequent bust.
In other words, Beshears and Milkman are saying that stubbornness is a significant contributor to not only stock market bubbles but crashes like the one investors experienced in 2008 and, to a lesser extent, the mini-crash of early this month.
The researchers acknowledge that market analysts are only human –and that, to some extent, it’s human nature to justify lousy decisions, a fact not lost on your ex-mother-in-law or the guy down the hall who bet on the Mets to go all the way this year. It’s the same idea on Wall Street when analysts won’t back down. “They want to recover their costs” and “hopefully vindicate themselves,” says Beshears.
The study draws the following conclusions from the data:
- As analysts got more and more extreme, or “out-of-consensus,” they became less and less responsive to the new earnings information when revising their full-year forecasts.
- Stubbornness hurts forecasting accuracy. Revised full-year forecasts from extreme incorrect analysts were further off the mark from actual earnings than they would have been had the analysts’ updating behavior been like the behavior of analysts who started at the consensus point.
- Analysts are punished for stubbornness. The more extreme, incorrect, and stubborn an analyst was, the less likely that he or she would rank among Institutional Investor magazine’s “All-American” list of top analysts.
So the next time a stock market analyst suggests investors double down on a toxic stock, beware.