Are small investors naïve?

Traditional economic analysis of markets with asymmetric information assumes that the uninformed agents account for incentives of the informed agents to distort information. We analyze whether investors in the stock market are able to account for such incentive distortions. Security analysts provide investors with information about investment opportunities by issuing buy and sell recommendations. The recommendations are likely to be biased upwards, in particular if an analyst is affiliated with an investment bank that is a recent underwriter of the recommended firm. Using the trading data from the New York Stock Exchange Trades and Quotations database (TAQ), we find that small (individual) investors do not account for these distortions. While large (institutional) investors generate abnormal volumes of buyer-initiated trades only after positive recommendations of unaffiliated analysts, small traders also exert abnormal buy pressure after positive recommendations of affiliated analysts. Since stocks recommended by affiliated analysts perform significantly worse than those recommended by unaffiliated analysts, small traders suffer losses due to their naiveté. Increased competition among analysts does not remedy the informational distortion and adverse welfare effects. * We would like to thank Nick Barberis, Stefano DellaVigna, Ming Huang, Josh Pollet, Richard Thaler and seminar participants at the University of Madison-Wisconsin and the SITE (Economics & Psychology) 2003 for helpful comments. JOINT USC FBE FINANCE SEMINAR & APPLIED ECONOMICS WORKSHOP presented by Ulrike Malmendier FRIDAY, October 3, 2003 1:30 pm 3:00 pm; Room: JKP-204