Sunday, January 14, 2018

Understand the incentive and you understand the analyst - Incentives create forecast biases


We didn't exactly believe your story, Miss O'Shaughnessy. We believed your 200 dollars. I mean, you paid us more than if you had been telling us the truth, and enough more to make it all right. 
-The Maltese Falcon 

It is difficult to get a man to understand something when his salary depends upon his not understanding it. - Upton Sinclair


Is research from Wall Street biased? My impression is that it is affected by a host of incentives including not being out of step with peers, pleasing management, and just not making a mistake. 

You cannot understand the forecast until you understand the man making the forecast. Does the analyst have an incentive to be biased? What master does he serve, the money manager client or the firm's traders and banking clients? Incentives matter and whenever you talk with someone in money management, you have to assess the incentives of the speaker. 

Given the potential for bias there is a need for regulation in order to further transparency. The positive impact of MiDIF II is that it changes the incentive structure for research. Money managers will have to pay for research directly and will ask for a return on that investment for the fund and for clients. Analysts will be beholden to the quality of their work not a myriad of alternative incentives. 

Similarly, when a hedge fund pitches an investor, there is also bias? Will a hedge fund ever say that it is not a good time to invest with their fund? Will a hedge fund manager admit failure or mistakes? Will hedge fund managers have an incentive to close a fund or return money? It happens, but should it occur more frequently? 

Even good managers and researchers can be unconscious biased toward their point of view. It is the burden of the investor to determine the incentives of the fund, its degree of bias and whether it is clouding the advice given. 

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