14 Mind Traps Afflicting Equity Research Analysts (Part 2 of 3)

This post covers this element(s) of GAMMA PI: #3. Make Accurate Stock Recommendations, GAMMA PI™ Area

Early in my career, I recall watching my sector (transportation) suddenly take off. Soon after, with the sector up 10%-15% despite no change in fundamentals (it was actually driven by portfolio managers attempting to get more exposure to cyclicals), I suddenly starting seeing reasons to get on board the bandwagon, which later turned out to be a mirage. Within a month, the entire sector came crashing down at which point I said to myself, “why didn’t I see this?” Many of us don’t see the bubbles forming because we create reasons to justify them such as, “it’s different this time,” or “it’s a paradigm shift.” All too often stocks return to reality and then we realize it’s not “different this time.”

As much we’d like to think we never follow the herd, it happens to all equity research analysts at some point in their career

This is Part 2 of a 3-part series on avoiding the most common mind traps that plague equity research analysts (see Part 1). This bulletin includes strategies for avoiding the mind traps that fall under categories I term “Following the Herd” and “Costly Psychological Shortcuts.” Understanding these traps, as well as best practices to eliminate them, helps increase the odds equity research analysts generate alpha. The first two pitfalls below, which I’ve categorized as “following the herd,” are among the most commonly witnessed in the market, leading to classic bubbles that eventually pop.

Following the Herd (social psychology)

BiasManifestationExampleBest Practices for Increasing Self-Awareness
Momentum BiasAssuming recent trends will continue, even if historical evidence and metrics suggest they are unsustainableAfter a recommended stock has rallied to a realistic price target, the analyst raises the valuation multiple or financial forecast to unrealistic levels to justify an even higher price target that ultimately isn’t achieved• If you’ve missed a substantial move in a stock, be hesitant to chase it such as jumping on the bandwagon. If you’re in the same trade as everyone else, ask “Who’s going to take the other side of the trade when I want to get out?”
• Research history for your companies and industries, specifically, the growth rates and valuation multiples. If your price target relies on one or both being well outside historical trends, make sure you have a sound reason for doing so.
• When making a change to your thesis, ask where you are in the “greed vs. fear” spectrum compared with consensus. If you’re in the same place, you may be following the herd.
• When markets appear to be moving too far too fast for irrational reasons (not based on fundamentals), consider the contrarian view
OverreactionSelling or buying at irrational prices with the herd, which in hindsight, was among the worst possible timesAn analyst downgrades a stock in response to bad news even though the research suggests the concern is being overblown• Before making a recommendation, document your thesis, price target and exit thresholds in an effort to remain disciplined in the face of market hype
• If the media or sell-side appear to be overreacting, update your scenario analysis to identify realistic worst-case and best-case scenarios
• Resist changing a stock recommendation mid-day or immediately after a company reports results (always try to “sleep on it” when it comes to major recommendation changes)

We all take shortcuts, including some in our professional lives. After all, if we use shortcuts to get more done in less time, we free up time for finding more alpha-generating ideas (or the “luxury” to leave work before 7 pm). But I’ve seen equity research analysts take dangerous shortcuts, resulting in bad stocks call due to insufficient research. In the table below I cover the three “costly psychological shortcuts” and tactics to avoid them.

Costly Psychological Shortcuts

BiasManifestationExampleBest Practices for Increasing Self-Awareness
Familiarity or Availability BiasPreferring stocks you’re familiar with over those you’re less familiar withWhen asked for your favorite stock, you reply with the one you’re most familiar with rather than the one that may have the most risk-adjusted upside• Don’t make recommendations of stocks you’re unfamiliar with, but conversely don’t make a suboptimal recommendation, just because you know the stock better than the proposed alternatives
• Ensure there are no “forgotten” stocks in your assigned universe, by setting aside time to ensure you are well-versed on all of them (yes, even the more complicated ones that are a pain to cover)
Recency BiasOver-emphasizing recent information, with little regard for older informationHaving a more positive bias toward a company you’ve recently met with, compared to one you haven’t seen for months• Avoid making recommendations where the stimulus is primarily based on a recent meeting or call with company management, especially if it’s initiated by the company
• Don’t ignore (or fail to research) the critical factors that moved a stock in the past because they often come back and move the stock in the future
Rules of Thumb (Heuristics)Blindly relying on or over-using mental shortcuts or heuristics to make investment decisions without verifying they are reliably accurateRecommending a stock or a sector every time its P/E ratio drops below 12x forward earnings, and selling every time it moves above 15x• When someone tells you to follow a “simple rule” in forecasting or valuation, validate it with historical analysis before using (if the rule always works, a computer would likely have arbitraged it away)

You might say you’ve never succumbed  to any of the mind traps above…but your mind may just be telling you that. If you’re convinced you are impervious to all of these traps (which often occurs with highly-confident professionals), review some of your bad stock calls to see if it’s plausible any of the elements above played a role. (AnalystSolutions provides equity research training with a workshop where we discuss how to spot and avoid most of these pitfalls.)

This Best Practices Bulletin™ targets activity #3, “Make Accurate Stock Recommendations” within our This Best Practices Bulletin™ covers the following elements of our GAMMA PI™ framework. In my next installment, I’ll post my thoughts about the last 5 of the 14 most common mind traps that impact equity research analysts. In the meantime, send me examples of how you were negatively impacted by the biases above. (I’ll keep your identity confidential.)

©AnalystSolutions LLP All rights reserved. James J. Valentine, CFA is author of Best Practices for Equity Research Analysts, founder of AnalystSolutions and was a top-ranked equity research analyst for ten consecutive years

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