A new paper co-authored by David Budescu, Ph.D., the Anne Anastasi Professor of Psychometrics and Quantitative Psychology, in the Journal of Behavioral Finance concludes that financial analysts are just like most of the rest of us: they’re overconfident.
“In psychology literature, there’s a lot of work on the accuracy of people’s probability judgments that suggest that in most situations most people are overconfident,” Budescu said.
“Analysts are no different. Things that affect predicting finance also affect predicting the weather and even geopolitical intelligence forecasts.”
The paper, co-authored by Ning Du, Ph.D., an associate professor of behavioral accounting at DePaul University, examines financial analysts’ earnings forecasts using quantitative psychology methods. The study analyzed over 200,000 annual earnings forecasts made by more than 6,000 analysts for more than 5,000 companies. It showed a “strong and persistent pattern by analysts to be overconfident,” said Budescu.
When looking at overconfidence, Budescu said that some domains and some professions are more forgiving than others.
“There’s a level of irreducible uncertainty, but it varies from domain to domain. So certain medical specialists are probably more accurate in their judgments, and weather forecasters are much more accurate when making prediction for short terms (24 – 72 hours),” said Budescu. “But when it comes to financial analysis, there is a much larger degree of unpredictability” because there are more factors to consider.
To measure overconfidence, Budescu and his team analyzed “hit rates,” a term used to measure their rates of spot-on predictions. In one case, the researchers aggregated the forecasts made by more than 6,000 analysts for more than 4,700 specific companies. They calculated the overall hit rate to be around 70 percent, which Budescu said sounds pretty good.
But this does not hold for all circumstances or companies. For example, the hit rate of the 34 analysts following Starbucks during the 2014 fiscal year was just 39 percent.
Budescu said there are “powerful psychological incentives” for professionals to be overconfident as advisers who are highly confident are often perceived as more accurate and trustworthy. And it hard to train people to overcome this tendency.
Moreover, people don’t always expect accuracy. An experiment Budescu and Du conducted with MBA students revealed that they did not expect financial forecasts to be very precise, and they actually valued the imprecision of the forecasts.
In fact, they rated a moderately imprecise forecast (for example, “the earnings per share of Company X will be between $0.05 and $0.13”) to be more informative and credible than their overly precise counterparts (for example, “the earnings per share of Company X will be $0.09”).
So why do we hire a financial analyst?
“An analyst following Starbucks, for example, will look at the coffee prices over the next two years, the size of the organization, and the way it is organized,” he said. “Whether it’s Starbucks or Apple, they understand the many variables that affect the performance better than we do.”