Did You See What I Saw? Interpreting Others’ Forecasts When Their Information Is Unknown

May 30, 2019

Did You See What I Saw? Interpreting Others’ Forecasts When Their Information Is Unknown
Anthony M Kwasnica; Raisa Velthuis; Jared Williams
Review of Finance, Volume 23, Issue 2, March 2019, Pages 325–361, https://doi.org/10.1093/rof/rfx0522

In many settings, people have access to a wide variety of information sources. Moreover, people can observe signals about others’ beliefs and private information. For example, in financial markets, investors can learn about a firm’s fundamentals by reading its financial statements, consuming its products or services, and reading news articles about the company. In addition, people can learn about others’ beliefs about the firm’s fundamentals by looking at the firm’s stock price, by talking to their friends and their financial advisor, and by reading financial analysts’ equity research about the firm.

How do people update their beliefs in such scenarios? In practice, this is a difficult task for an individual, because it is unclear whether others are relying on the same sources of information as her. If everyone is looking at the same information, there is likely to be little value in others’ forecasts, but if everyone is observing different information, the incremental information of others’ forecasts is likely to be large.

We examine how people update their beliefs in these scenarios by conducting a series of forecasting experiments. The context of our experiment is earnings forecasts for a hypothetical firm. In our baseline treatment, subjects choose which of two information sources to observe, and they issue initial forecasts. After issuing an initial forecast, subjects observe the initial forecast of a randomly chosen subject, and they issue revised forecasts. We find that subjects tend to underreact to the information contained in others’ forecasts. To determine what drives this underreaction, we design additional treatments and we compare subject behavior across treatments. We find that much, but not all, of the underreaction can be explained by “cursedness” (Eyster and Rabin, 2005), that is, a propensity to underestimate the link between others’ actions and their information. In addition, we show that the behavior of sophisticated subjects is not affected by the framing of information, but unsophisticated subjects actually switch from underreaction to overreaction when they are only provided with qualitative forecast information as opposed to both qualitative and quantitative forecast information. Specifically, when we inform an unsophisticated subject that another person observed bullish information about the firm and we reveal the other person’s quantitative forecast, the unsophisticated subject will generally underreact to the information. However, when we only inform the unsophisticated subject that the other person observed bullish information, the unsophisticated subject will generally overreact to that information even though, in our setting, the information content in the two disclosures is exactly the same.

Our results have important implications for the way that financial analysts aggregate information and the way that financial institutions present forecasts to their clients. For example, to the extent that brokerages want to generate trading volume, our findings might explain why brokerages generally emphasize the qualitative features of analysts’ forecasts (“buy” versus “hold” versus “sell”) rather than the quantitative features of analysts’ forecasts (price targets and EPS forecasts).