Investors naturally expect analysts’ evaluations and recommendations to be objective. However, it is important not to overlook the fact that analysts, being human, can exhibit biases. Particularly, recent studies have revealed that analysts can sometimes be likened to bad teachers.
Commonality Between Analysts and Teachers
Both teachers and analysts tend to evaluate students (companies) based on their relative advantages compared to peers (other companies) rather than absolute merits. This ‘curve grading’ is beneficial to no one. Just as an unqualified student can graduate with high honors for being less stupid, in the stock market, a pig with lipstick can receive a “buy” rating.
Recent research points out that this phenomenon frequently occurs in the stock market. In an ideal world, analysts would provide buy/hold/sell ratings based on absolute standards or sector averages. However, the reality is different. Analysts cannot cover all stocks in each sector, so the choice of stocks they cover influences their ratings.
Case of Curve Grading
For example, imagine a sector composed of five stocks, and two analysts each covering three of them. Suppose stock A is the most expensive, followed by stock B, stock C, and stock E is the cheapest. If Analyst I covers the three most expensive stocks, and Analyst II covers the three cheapest stocks, what would happen?
Analyst I is likely to rate the cheapest stock they cover, stock C, as a buy. Meanwhile, Analyst II might rate the same stock C as a sell. Thus, the same stock can receive different ratings because of the different compositions of stocks covered by each analyst.
Ways to Overcome Bias
To reduce such biases, it is important to trust evaluations from more experienced analysts. Experienced analysts can evaluate stocks from a broader perspective. As investors, we should value the opinions of seasoned analysts over those of newcomers.
Conclusion
In the end, it is crucial for investors to recognize analysts’ biases and refer to the opinions of experienced analysts. This can be an essential guideline for making better investment decisions, beyond merely choosing stocks.
Reference: Klement on Investing, “The one-eyed among the blind and the seeing”