Does it Matter if Stock Analysts Disclose Their Investments?

Important financial regulations may currently be withering on the vine, but patriotic wall street job creators still have some rules they must obey. One such rule, which comes from the Sarbanes–Oxley Act of 2002, mandates that stock analysts disclose conflicts of interests. Because analysts stand to profit if hordes of people try to buy stocks they own, it makes sense that they ought to let people know where they stand.

In theory, disclosures allow citizens to make better decisions, but it’s not entirely clear that’s the case. A recent study (pdf) led by Duke’s Sunita Sah suggests that when doctors disclose a professional or financial interest in a certain procedure, patients will see the recommendation as biased, but they’ll also feel social pressure to be of assistance. In the end this can make them more likely to take the doctor’s advice:

Disclosure of a doctor‘s financial or non-financial conflict-of-interest has an adverse effect on the doctor-patient relationship. It decreases trust in the doctor‘s advice, which is, however, accompanied by increased pressure to  comply with the doctor‘s disclosed interest. Thus, instead of being merely a warning, disclosure  can become a burdensome request to comply with advice that is trusted less.

Sah also conducted a series of follow-up experiments based around an artificially constructed advice-giving scenario. These experiments also found that when an adviser revealed he had something to gain from the deciding participant’s decision, the decider became more likely to follow the advice. However, there was an exception. When the disclosure was made by a third party, and thus the decider couldn’t assume that the adviser knew that he knew (stay with me), the disclosure did not make the decider more likely to follow the advice. It would seem that when the social relationship was more tenuous, or when there was no shared knowledge about the disclosure, there was less pressure to comply.

How might disclosures play out with regard to financial trading? A new study by Pepperdine’s Ahmed Taha and Wake Forest’s John Petrocelli sought to find an answer. Taha and Petrocelli examined how three samples of participants — MBA students, law students, and undergraduates — reacted to reports on two different imaginary steel companies that were written by two different analysts. One analyst owned stock in the company he was writing about, and participants saw one of three different versions of his reports. One version had a standard disclosure that said the author owns stock in the company being written about. A second version had the same disclosure, but with additional text that explained the analyst could gain if the reader purchased the stock. A third version contained no disclosure, and thus the two reports participants in this condition saw were essentially equivalent. Participants were then given an imaginary $10,000 to allocate between the two companies.

The researchers found that disclosure of ownership led participants to invest less money and view the analysts as more dishonest. When it came to the two disclosure conditions, the condition that explained why ownership was a conflict of interest had a stronger effect than the condition in which disclosure was simply made.

Taha and Petrocelli explain:

These results suggest that the perceived honesty and confidence of analysts is affected by whether and how it is disclosed that the analysts own stock in the companies they are recommending, and in turn, this perceived honesty and confidence affect investors’ investment decisions. Disclosure of analyst ownership reduces investment at least in part because investors question the honesty and confidence of an analyst who recommends stocks that the analyst owns.

Does this square with the results from Suh’s study? It would seem so. While the analyst’s disclosures were public and known to both the analyst and the reader, the impersonal nature of written stock reports means that people are unlikely to feel much social pressure to comply with the recommendations. So, good for Sarbanes-Oxley! It makes people distrust stock analysts, and because Joe Six-Pack can’t beat the stock market, anything that discourages him from trying to do so is a good thing.

One remaining question is whether the results might be different if the investor has a more personal one-on-one relationship with their analyst. That seems more akin to the medical advice situation, and it could lead a case where Sarbanes-Oxley pressures people into making poor decisions.
Taha, A.E., & Petrocelli, J.V. (2013). Sending Mixed Messages: Investor Interpretations of Disclosures of Analyst Stock Ownership Psychology, Public Policy, and Law DOI: 10.1037/a0033915

Sah, S., Lowenstein, G., & Cain, D.M. (2013). The Burden of Disclosure: Increased Compliance with Distrusted Advice Journal of Personality and Social Psychology DOI: 10.1037/a0030527

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