The Asymmetry of Analyst Ratings

Nov 16, 2013 by Adam Powell

In general, I sell if analysts have turned against a stock, relative to others in its category. I recently sold the stock of a major bank because it had been downgraded. While it was at 95% of its 52 week high, tides were turning against it. When I re-evaluate my stocks, I go through each of the stocks that has been downgraded and decide whether I should reallocate my money towards stocks with more positive sentiment. A downgrade is a more important trigger to me than a price drop.

One of the reasons that I take downgrades as a sell signal is because analysts have incentives to have an optimistic bias. When optimists become pessimistic, it tends not to be a good thing. As this bias is asymmetric, I don’t use analyst ratings to decide when to buy a stock, but I do use them to decide when I should consider selling a stock. Ratings are a leading indicator of where the market might be going on the stock. Some investors have policies of not buying poorly rated stocks. Thus, these policies make poor ratings a self-fulfilling prophecy.

Here are some articles that document that optimistic bias of analysts:

• The Bias of Wall Street Analysts
• The Competing Incentives and Pressures that Influence Sell-Side Analysts