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Security analysts tend to bias stock recommendations upward, particularly if they are affiliated with the underwriter. We analyze how investors account for such distortions. Using the NYSE Trades and Quotations database, we find that large traders adjust their trading response downward. While they exert buy pressure following strong buy recommendations, they display no reaction to buy recommendations and selling pressure following hold recommendations. This “discounting” is even more pronounced when the analyst is affiliated with the underwriter. Small traders, instead, follow recommendations literally. They exert positive pressure following both buy and strong buy recommendations and zero pressure following hold recommendations. We discuss possible explanations for the differences in trading response, including information costs and investor naiveté.

Stock recommendations of security analysts exhibit a strong upward bias. While the scale of recommendations ranges from “strong sell” and “sell” to “hold,” “buy,” and “strong buy,” only 4.5% of all recommendations recorded in the IBES data set through December 2002 are in the strong sell and sell categories. Analysts’ true scale appears to be shifted upward. The upward bias is even more pronounced for analysts who are affiliated with the underwriter of the recommended stock. In this paper, we document the trade reaction of investors to recommendations. Using the NYSE Trades and Quotations database, we investigate how large and small traders respond to recommendations issued by affiliated and unaffiliated analysts. We find three main results. First, both large and small traders display significant trade reactions. But only large traders adjust their trading response to the upward distortion. They exhibit a positive abnormal trade reaction to strong buy recommendations, no reaction to buy recommendations, and significant selling pressure after holds. Small traders, by contrast, follow recommendations literally. They exhibit a positive abnormal reaction to both buy and strong buy recommendations and no reaction to holds. Second, large traders react significantly less positively to buy and strong buy recommendations if the analyst is affiliated. Small traders, instead, do not respond differently to affiliated recommendations. Third, small investors appear to take less account of the informational content of a recommendation change (or the lack thereof). For example, small investors respond positively to mere reiterations of unaffiliated buy and strong buy recommendations, while large investors do not display any significant reaction. The results are robust to alternative econometric specifications, including alternative investor and analyst classifications, controls for analyst and brokerage heterogeneity, and tests for front running of large traders. Our results reveal systematic and robust differences in how small and large investors react to analyst reports. It is harder to pin down the explanation for these differences. One possibility is that information about analyst distortions is more costly for small investors—the costs of adjusting their trading behavior outweigh the benefits. In fact, the benefits could be small or even zero due to the arbitrage of large investors. Alternatively, small investors might not seek information about analyst distortions even if the costs of obtaining such information are low. They take recommendations at face value and trust analysts too much, in line with experimental results on advice-giving with misaligned incentives and the literature on investors’ reaction to firms’ accounting choices and security issuance decisions (Cain, Loewenstein, and Moore, 2005; Daniel, Hirshleifer, and Teoh, 2002). To differentiate between these explanations would require estimates of the costs of and returns to information about analyst distortions. However, informational costs are hard to measure objectively. The returns are, in principle, easier to calculate, but the NYSE Trades and Quotations database does not allow such calculations since it reveals only aggregate trade imbalances, not investors’ portfolio strategies. As a second-best approach, we analyze the relation between abnormal returns and trade imbalance. Using an event-study methodology, we find that small investors’ net (buy minus sell) trade reaction predicts significantly lower abnormal returns than large investors’ net trade reaction over six and twelve months. The difference is insignificant if we assume a three-month holding period. We also calculate the portfolio returns to a trading strategy that takes recommendations literally, i.e., buys after buy and strong buy recommendations and sells after sell and strong sell recommendations. Using the Fama-French four-factor portfolio method, we find mostly insignificant abnormal returns. Two additional results shed some light on the underlying motives of small investors. First, investors face 94.5% positive and neutral recommendations, revealing the general distortion at no (additional) cost to those who trade in response to recommendations. Thus, rational small investors should be aware of the general upward shift of recommendations by all analysts. Nevertheless, they fail to account for it. Second, while it might be costly to distinguish affiliated and unaffiliated analysts and to identify the additional distortion of affiliated analysts, small investors can minimize the cost by focusing on analysts who are most easily identified as “independent”: analysts whose financial institutions are never involved in underwriting. However, we find that small investors display less abnormal trade reaction to such analyst recommendations. Our paper builds on a large literature on the informational distortions of analysts (Francis, Hanna, and Philbrick, 1997; Lin, McNichols, and O’Brien, 2003, among many others). Several papers document that the recommendations of affiliated analysts are more favorable than those of unaffiliated analysts (see, e.g., Dugar and Nathan, 1995; Lin and McNichols, 1998; Michaely and Womack, 1999). The high ratio of buy over sell recommendations indicates that even unaffiliated analysts do not provide a balanced view (Michaely and Womack, 2005).1 Previous analyses of investor reaction to recommendations have been largely based on return patterns. Womack (1996) finds significant three-day event returns to recommendation changes in the direction of the change. The evidence on return differences if analysts are affiliated is mixed. For initial public offering (IPO) underwriting affiliation, Michaely and Womack (1999) show that both the initial positive reaction to upgrades and the post-recommendation drift are stronger if the analyst is unaffiliated. For secondary equity offering (SEO) underwriting affiliation, Lin and McNichols (1998) find that the market reacts significantly more negatively to affiliated than to unaffiliated hold recommendations, but they do not find significant differences in the longer run. Iskoz (2002) shows that institutions account for analyst bias, as far as one can deduce from quarterly institutional ownership data. Mikhail, Walther, and Willis (2006) also analyze the reaction of small and large investors to recommendations, but use dollar trading volume. Their general results are consistent with our findings, though they do not find significant results for affiliated recommendations, possibly due to the skewness of the dollar measure for large trades. We complement the previous findings in three ways. First, we document the trading response to affiliated and unaffiliated recommendations using measures of buyer and seller initiation as in Odders-White (2000). Second, we distinguish between small and large investors, using the trade-size algorithm developed in Lee and Radhakrishna (2000). We show that large investors—a group dominated by firms and their associated professionals—account for analyst distortions, but small investors do not. Third, we investigate the costs of and returns to adjusting for analyst distortions and relate them to different explanations for the observed trade reaction. In the remainder of the paper, we first provide details on the various data sources and classification schemes for investors and analysts (Section 2), including evidence of analyst distortions. Section 3 presents our core result. It documents the trade reaction of small and large investors to analyst recommendations. In Section 4, we discuss potential explanations and provide a partial analysis of the costs of and the returns to informed trading. Section 5 concludes.

Analysts tend to positively bias the information they provide to investors, as evident in the very low number of sell and strong sell recommendations. While large investors adjust their reaction to hold and buy recommendations downwards, small investors take recommendations literally. Small investors also fail to account for the additional distortion due to underwriter affiliation. Potential explanations are higher costs of information and naiveté about distortions in analyst recommendations. We shed some light on the plausibility of these explanations by evaluating the costs and benefits of information about analyst distortion. Lacking information about portfolio strategies, we are limited to measuring the event returns to net trade imbalances and the portfolio returns to a strategy that takes analyst recommendations literally. The event returns to small traders’ net trade reaction are significantly lower than those of large traders if we assume six- or twelve-month holding periods; the difference is insignificant over three months. The portfolio returns are mostly negative but insignificant, at least before transaction costs. The portfolio returns are significantly negative even prior to transaction costs for stocks with low institutional interest (small and low-coverage stocks). Thus, many of the return results are consistent with a rational model of small investors’ trade reaction, though at best a very noisy proxy for the return implications of the response to recommendations. It is harder to explain in a standard framework why only large traders but not small investors adjust their trade reaction to the general upward bias of analyst recommendations, given that there seem to be some conditions under which it would be more profitable to make that adjustment and given that the general upward bias is visible to any trader reacting to recommendations. It is also striking that small traders do not focus on analysts from independent brokerages. The latter findings suggest that small investors are naive about the distortions and trust analysts too much.