How You Can Beat Wall Street at Their Own Game

Stock analysts are actually incredibly biased when it comes to making recommendations. Here are three ways to beat them -- and yourself.

Jun 15, 2014 at 12:30PM

Flickr / nromagna.

For all their efforts, analysts tend to be wrong, not only because forecasting is tricky, but because of psychological biases that can affect all investors. Here are a few tips to avoid the pitfalls that so many analysts (and other investors) tend to fall into. 

Think forward, not backwards
Analysts often work for large banks, which provide underwriting services to the same companies these analysts are writing about.

Bad reviews are associated with losses of access to management and the switching of underwriters, so analysts have an incentive, however subtle, to be more optimistic than they should be. This ends up affecting their reports and recommendations -- studies find that analysts tend to give in to their optimistic biases.

You, of course, don't face the same conflicts of interest with the companies you're analyzing, but you might be facing conflicts of interest within yourself.

These usually take the form of looking for evidence that confirms the things that you want to be true, either because you're literally invested in the result, or because it would be a blow to admit you're wrong. 

Flickr / Anderson Mancini.

Behavioral scientists call this confirmation bias. It's like selective listening: You hear what you want to hear and filter out the rest, regardless of whether it's important or not. The problem with confirmation bias is that you end up ignoring evidence that goes against what you already believe, and you don't apply rational analysis to the evidence that supports your beliefs.

How to avoid it? Deliberately seek out information that disproves what you believe, whatever it is.

This can be hard to stomach at first, but if you make it a habit with every investment, you might find that it becomes kind of fun. Take your investment thesis, whatever it is, and actively try to prove yourself wrong. You might find that your beliefs hold up, or you might develop a more nuanced one. You might also completely change your mind. 

Familiarity should breed contempt
Okay, maybe not contempt, but certainly suspicion.

Analysts tend to ignore a lot of stocks -- the result is that a lot of analysts cover large banks, like Bank of America, and very few cover small banks.

Part of the reason for the oversight might be the conflicts of interest described above, but it might also have something to do with familiarity. We are simply more comfortable with what we know, even if that just means recognizing a brand name. This explains why you might tend to walk into a Starbucks whenever you're traveling, instead of trying out a local coffee shop.

Try to recognize that you might be predisposed to a stock simply because you're hearing about it all the time.

Like most things in the media, a company isn't necessarily better just because everyone is talking about it. Try to give time and analytical horsepower to stocks that are outside the popular investing universe -- you might come up with some crazy ideas, but you may also find greener pastures.

Flickr / thenails. 

Following the herd 
Similarly, research has also found that analysts tend to be followers; for example, they tend to be the most pessimistic after the worst part of a downturn, when things are already looking up. We do the same thing as investors. Even though everyone knows you should buy low and sell high, it's awfully hard to do when everyone around you is in a buying frenzy -- or running for the exits.

How to avoid falling into the trap? Adopt that timeless wisdom of Warren Buffet, "Be fearful when others are greedy and be greedy when others are fearful." If you're feeling giddiness in the market, take note. Same goes for panic. 

All in all, take pride in being on your own as an investor instead of worrying about what everyone else is doing. It will be hard, and it will certainly be a bit lonely, but it will set you apart from the analysts -- not to mention everyone else.

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