The inability of stock analysts and others to say, “Oops, I was wrong” may help cause even more serious damage in the stock market over time.

That’s the gist of new research published in the Journal of Economic Behavior and Organization. When some stock analysts break from the pack to make bold earnings predictions -- but then find that they were wrong -- they tend to stick with bold predictions anyway, the research found.

"That stubbornness alone isn’t enough to create a boom and boost cycle," said John Beshears, an assistant professor of finance at the Stanford Graduate School of Business who co-authored the study. "But it can exacerbate such a cycle by delaying [the] moment of reckoning."

Beshears says the mechanism pinpointed by he and his co-author, Katherine Milkman, of the Wharton School at the University of Pennsylvania, could help lead to mispricing of assets -- with nasty results.

Take the financial crisis of 2007-2008, says Beshears. Despite initial signs of a weakening real estate market, many analysts, investors, and lenders maintained or stepped up their commitment to mortgage-backed securities and other housing-related assets, he notes.

As a result, the housing bubble continued longer than it should have, delaying and exacerbating the subsequent bust.

Once a company reports quarterly earnings showing that an analyst was far too optimistic or too pessimistic, that analyst will revise his or her full-year forecast, the researchers found -- but will move less aggressively in the direction of the earnings surprise than other analysts.

The psychological biases that help shape market participants’ behavior have been noted in previous research, which shows that when people make decisions that turn out to be wrong, they try to justify them. They are reluctant to back down because they may have invested time, money and effort into a decision and they also wish to be vindicated, Beshears said.

Beshears’ and Milkman’s paper, “Do Sell-Side Stock Analysts Exhibit Escalation of Commitment?” appeared in the Journal of Economic Behavior and Organization.

The duo studied a database with more than 6,200 analysts’ quarterly forecasts on about 3,500 companies over more than 18 years, from 1990 to 2008. The results may pop another hole in the idea of rational markets.

"There’s mounting evidence to suggest that the market does not always get it right," Beshears said. "This is one piece of the puzzle."

Among their specific findings:

-- As analysts got more and more extreme, or “out-of-consensus,” they became less and less responsive to the new earnings information when revising their full-year forecasts.

-- Analysts are punished for stubbornness. The more extreme, incorrect, and stubborn an analyst was, the less likely that he or she would rank among Institutional Investor magazine’s “All-American” list of top analysts.

Beshears said the research on escalation bias can be extended from equities to the debt markets to shed light on how players such as credit analysts, loan officers and risk management experts view the performance of financial assets.



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