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Toward an Understanding of the Risky Choice Behavior of Professional Financial Analysts

Several studies have reported inefficiencies and/or biases in analysts' ability to incorporate new information into their earnings forecasts. We propose that an important psychological factor associated with optimistic earnings forecasts is the propensity of analysts to engage in risky choice behavior as described by prospect theory. Furthermore, the motivational incentives faced by analysts may exacerbate risky choice behavior during forecast revision, thereby magnifying overestimates of earnings. Sixty professional financial analysts were asked to issue a first quarter and then an annual EPS forecast of a company. The analysts were randomly assigned to two initial forecast accuracy conditions that indicated their initial forecast earnings was 1) essentially the same as actual earnings, or 2) substantially higher than actual earnings. Analysts were also assigned to one of three motivational incentive conditions indicating the analyst and brokerage firm would 1) have no future contact with the forecast firm, 2) begin to follow the forecast firm, or 3) establish an underwriting relationship with the forecast firm. The results indicate that analysts who perceived a loss function due to the inaccuracy of prior earnings forecasts tended to choose riskier prospects in subsequent forecast revisions than analysts who perceived their prior earnings forecasts to be accurate. These riskier prospects translate into greater overestimates of earnings. Furthermore, while the average risk attitude of the analysts was optimistic, higher levels of motivational incentives were associated with greater risk-seeking behavior by the analysts who perceive a loss function. It appears that the motivational incentives inherent in brokerage firms can exacerbate the risky choice behavior of financial analysts during forecast revision. These findings support the utility of incorporating both cognitive and motivational factors into the prediction of analyst behavior.