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Earnings Forecasts Can Be BiasedAugust, 2002 ONE OF THE HALLMARKS of the U.S. market economy is its transparency: Companies report public balance sheets so investors are willing to take risks based on information they can trust to be true. But in our post-Enron world, that transparency has been called into question. How does the investor, especially the individual investor, know which voices to listen to in the clamor of financial information? And what regulations of securities analysts would restore the climate of trust? One big step is to identify a predictable pattern of bias in the work of successful financial analysts and understand how that bias is rewarded. A recent paper by associate professor of finance Harrison Hong does just that. Many people have known by casual observation for years that market analysts tend to issue optimistically biased earnings forecasts for the stocks they recommend. Hong's research attempts to explain why this is the case. He notes three possible explanations: The "career concern perspective" (analysts are somehow rewarded for their optimism by their employers); the "selection bias" (analysts tend to cover the stocks they can recommend over stocks they cannot); and the "cognitive/behavioral bias" (analysts tend to like the stocks they cover). "If you listen to the Enron debate," Hong says, "all the senators and congressmen are going for the first reason; but the analysts point to the second and third explanations of this bias." A number of the School's professors have researched various aspects of information and the markets. Maureen McNichols (The Trouble with Good News, Stanford Business, June 1997) and Ezra Zuckerman (Why Analysts Don't Rock theBoat, May 2001), for example, also have examined securities analyst bias. All these studies are relevant to regulators who base their rules and conventions in part on the quality of available corporate information. Hong and his coauthor, Jeffrey Kubik, assistant professor of economics at Syracuse University, compared brokerage house employment and earnings forecast histories of roughly 12,000 analysts working for 600 brokerage houses between 1983 and 2000. Other studies in this area had argued that analysts' forecasts are, on average, optimistically biased. Alleging rewards for this optimism, researchers pointed to evidence that an analyst from a brokerage house that has an underwriting relationship with a stock tends to issue more positive predictions than analysts from non-affiliated houses. Hong's work takes this a step further. His research points to a reward system for optimism that is more implicit than explicit, as long as the optimism is within a range of accuracy that maintains the credibility of the analysts' skills. Analysts who are optimistic are much less likely to be fired from a top brokerage house and much more likely to be promoted or hired by a better house. They also are given the better assignments. "Look at Henry Blodgett, the key guy at Merrill Lynch. Even after it was clear that all the dot-com stocks he recommended were busts, he was promoted to be the lead analyst on Microsoft," Hong notes. The study also finds that analysts are judged less on accuracy when it comes to stocks underwritten by their houses. "Among analysts who cover stocks underwritten by their brokerage houses, job separations depend less on forecast accuracy and more on forecast optimism," Hong says. "This pattern was even more pronounced in the mid to late nineties than in the eighties and early nineties." If the relationship between the analyst's brokerage house and the stock he or she is promoting can influence forecasting, how does the private investor track the relationship? "There are Internet sites starting up÷Yahoo, E-Trade, etc.÷that can help track information about analysts," Hong says. So what about regulating the analysts? Hong says that the post-Enron outcry to have securities analysts disclose which stocks they are buying for their personal portfolios is too narrow a regulation. His study shows that the real benefits to the analysts for their optimism are much subtler and that career concerns such as an analyst's reputation, hiring and firing patterns, and the allocation of jobs would be very difficult to regulate. Hong's recommendation: "We may want to have some version of a public education warning, alerting the private investor to listen to forecasts, especially positive forecasts from an analyst covering firms that have investment banking relationships with her brokerage house, at their own risk." ÷LISA EUNSON Analyzing the Analysts: Career Concerns and Biased Earnings Forecasts,Harrison Hong and Jeffrey Kubik, GSB Working Paper; Journal of Finance, forthcoming
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Earnings Forecasts Can Be Biased 
