Chapter 11
MARKET EFFICIENCY AND BIASES
IN BROKERAGE RECOMMENDATIONS
Roni Michaely and Kent L. Womack
IntroductionThe study of decision making by security analysts, specifically the decisions
by sell-side analysts to issue buy, sell, or hold recommendations on stocks,
provides evidence on some of the most fundamental questions in finance.^1
Among these are, Can analysts identify future winners and losers? If so,
how quickly do prices incorporate the information value of these recom-
mendations? Do investors’ profits from these recommendations exceed
transaction costs? Can analysts intentionally manipulate stock prices even
temporarily from their equilibrium values? And perhaps most importantly,
What does the evidence about analyst recommendations say about the effi-
ciency of financial markets?
If markets are efficient, one presumes that market participants are not
able to consistently forecast future out- and under-performers. Analyst rec-
ommendations offer one of the purest tests of whether investment “skill”
exists. Security analysts are usually industry specialists, typically covering
between five and twenty-five stocks. They regularly keep a portion of the
stocks they follow on their “buy list” and maintain a quasi-numerical rat-
ing of all stocks within their followed universe. A significant aspect of their
job is to update this relative valuation information on the stocks they fol-
low and transmit this information to their customers. It seems clear that
this level of specialization qualifies them as “informed investors” in the
Grossman (1976) sense if indeed informed (non-insider) investors exist.
Thus, there is a reason to believe that analysts’ efforts to become informed
may lead to the corresponding superior performance of the stocks they rec-
ommend. In equilibrium, with analysts competing with each other, the mar-
ginal cost of gathering and obtaining this information should be equal to its
marginal benefit, or the rent analysts (or their firms) receive. Those rents
We would like to thank Leslie Boni for her valuable comments.
(^1) “Sell-side analysts” are securities analysts employed by banks and brokerage firms. “Buy-
side analysts” are those employed by institutional investment firms, such as pension funds,
mutual funds, and insurance companies.