Should You Listen to Your Broker?

New research shows that you should pay careful attention to what your stock broker says.
Then do the exact opposite.

It turns out, there is information in analyst forecasts, specifically, shorting your broker. In Long-Term Earnings Growth Forecasts, Limited Attention, and Return Predictability by Da and Warachka, they find that if you take the long-run earnings growth and divide by the recent earnings growth, you get a straightforward metric of optimism: higher is more optimistic. It turns out, the highest decile has a 4% annualized lower risk-adjusted return than the lowest decile; more optimistic stocks have lower returns.
A simple explanation (see here) is that mutual funds “herd” (trade together) into stocks with consensus analyst upgrades and (especially) herd out of stocks with consensus downgrades. Stronger fund herding occurs when analyst recommendation revisions are more unanimous.
However, there is some information that analyst recommendations are more useful at the industry level. Portfolios long in industries about which analysts are optimistic and short in industries about which analysts are pessimistic generate significant abnormal returns (see here).
So, listen to your broker’s advice on sectors and stocks, just remember to short the stock picks.

Posted by on January 25th, 2010 at 10:34 am


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