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Chapter 5. Profits from the Prophets? > The Biases of Analysts

The Biases of Analysts

Be aware that securities analysts are human, and thus they are influenced by the same psychological biases and emotions as the rest of us. They tend to follow a specific industry and get attached (see attachment bias in Chapter 2, “Behavioral Finance”) to the firms in that industry. Despite their rigorous training in stock valuation, analysts can completely disregard traditional theory during periods of stock market mania. During the tech stock bubble, most analysts encouraged the purchase of stocks that already had prices over 10 times their reasonable value. For example, making aggressive and optimistic assumptions in traditional valuation models, DoubleClick, Inc. was worth less than $7 per share in late 1999 and early 2000. Its stock price was over $120 per share. Yet, analysts were forecasting even higher prices and recommending a Strong Buy. Indeed, by mid- to late 2001, the stock was trading in the much more appropriate $7 to $10 range. Of course, this wasn't good for investors who bought DoubleClick at $100 per share (or more) based on those recommendations.

The changing financial environment of the 1990s has caused (or made worse) a conflict of interest for analysts. Most financial firms earn their income from three sources: (1) investment banking, (2) brokerage services, and (3) proprietary trading. Proprietary trading is the trading and investing of the firm's own money. Brokerage services are the fees generated from the activities of other investors, like commission fees and market-making activities. Competition from the rise of discount brokerages in the 1980s and the deep discount online brokerages in the 1990s reduced this income for traditional financial firms. The largest source of income is the investment banking activities, which include helping firms issue stocks, bonds, and other securities. The fees from helping a firm go public in its initial public offering (IPO) can be in the tens of millions of dollars.


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