The first five parts of this series focused on financial advisers. The next few will hit far closer to my former Wall Street home. As I described in my disclosure, while working as a Wall Street research analyst, I experienced both the apex and nadir of the business. For legal reasons, I unfortunately can’t say much about my personal experiences, but I can say that, even after the recent research reforms, many misconceptions remain.
For example, when a Wall Street analyst rates a stock “Buy,” is he or she advising you to buy it? Actually, no. In most cases, a “Buy” rating—or, for that matter, a “Sell,” “Hold,” “Outperform,” “Accumulate,” “Avoid,” “A,” “D,” or other term—is not intended to advise you, a specific investor with specific goals, circumstances, and requirements, to do anything. Why not? In part because analyzing a stock is less than half of the work required to make a buy or sell decision. And in part because a “Buy” for one investor will always be a “Sell” for another, regardless of the outlook for the stock.
Any investment decision, in other words, involves at least two analyses: 1) an analysis of the stock; and 2) an analysis of the goals, risk tolerance, investment style, time horizon, and portfolio composition of the investor. In most cases, the decision also involves analyses of asset classes (stocks, bonds, etc.), relative industry attractiveness (technology vs. healthcare, etc.), and other stocks in the sector (if you’re going to buy one semiconductor stock, is this the right one?). At most Wall Street firms, these analyses are conducted by different professionals: the stock analyst, the portfolio strategist, and the financial adviser. Without knowing the circumstances and requirements of particular investors, a stock analyst cannot make recommendations to specific clients.
This, of course, flies in the face of much commentary about Wall Street research. Firms that use “Buy” ratings are often described as “urging investors to buy,” and firms that try to avoid this misunderstanding by using words like “Outperform,” “Attractive,” etc., are often described as employing an “equivalent of ‘Buy.’ ” The use of ratings like “Buy,” “Sell,” and “Hold” doesn’t help minimize confusion, but most firms actually don’t use these terms. They also take pains to explain that ratings are not action recommendations. The world craves simplicity, however, and no matter how carefully defined, a rating at the high end of a firm’s scale is usually described as a “recommendation to buy.”
Lest a discussion of rating complexities sound like a defense of euphemism and circumlocution—”Can’t they just tell me what to do?”—consider the role of the sector analyst in the investment process. Responsible investing does not start with industry-specific stock-picking, the purview of most stock analysts. Responsible investing starts with asset allocation (the percentages of a portfolio that one places in stocks, bonds, cash, etc.). It then moves through multiple decisions in descending priority:
- Asset allocation (stocks, bonds, cash, real estate, commodities, etc.);
- Investment style selection (value, growth, etc.);
- Manager selection (active, passive, high-cost, low-cost, etc.);
- Industry selection (technology, healthcare, etc.); and, finally,
- Security selection (“good” stocks vs. “bad” ones)
Stock-picking is the last decision in the hierarchy, and, importantly, it is the least critical. Studies suggest that asset allocation and costs account for most of the variability of investment returns; security selection, meanwhile, accounts for only a fraction. Picking the wrong stock in an intelligently diversified portfolio, in other words, is merely annoying. Making the wrong asset allocation decision can be devastating.
In any case, a stock analyst comes into play only at the end of the investment process, and only to help answer the questions: “Which stocks in this particular industry will do better than others?” and “How well might they do?” These questions, not surprisingly, are of greatest importance to professional investors, who can beat “benchmarks” only through superior stock-picking. For casual investors, however, the questions are (or should be) almost irrelevant. As I argued in a previous piece, the vast majority of casual investors shouldn’t try to pick stocks at all (unless they’re doing it for fun). Instead, they should master the overall investment process, from asset allocation on down.
If casual investors do decide to pick stocks, they should keep in mind that, again, one investor’s “Buy” is always another’s “Sell.” When Google goes public, for example, it will be a high-risk, high-volatility stock. As a result, it will be suitable only for aggressive investors—those willing to accept the possibility of significant losses in exchange for the possibility of significant gains. Even before considering the outlook for the stock, therefore, Google will be a “Buy” for only a small percentage of investors and a “Sell” for the vast majority. Within the “aggressive investor” category, moreover, Google might be a “Buy” for some and a “Sell” for others. For a 24-year-old with a long time horizon, a small investment might make sense. For a soon-to-retire 63-year-old, meanwhile, an investment would probably be ludicrous. An investor who already has 40 percent of his or her portfolio in technology stocks should probably sell Google (too much concentration risk), while an investor with no technology exposure might want to buy.
Wall Street firms try to deal with the limitations of ratings by defining what they mean—and they mean very different things at different firms. Some rating systems, for example, are “absolute”: The analyst is asked to judge whether the stock will go up or down a specified amount over a specified period (usually a year or two: Ratings do not indicate what the analyst thinks the stock is going to do next—one of the biggest misconceptions about ratings and a big headache for analysts. In 1998, for example, when I put a $400 target on Amazon.com—$66 in today’s split—I was suggesting that the stock might hit that level in a year or more; I also expected that, in the intervening six to nine months, it might plummet. The press coverage, however, seemed to suggest that the target was for that afternoon.) Other rating systems are “relative”: The analyst is asked to judge not whether the stock will go up or down but whether it will do better or worse than a market or industry benchmark.
Each type of system has strengths and weaknesses. In an “absolute” system, the analyst has to form opinions about not only the company and industry but the market, because market performance is usually the most important determinant of stock performance (in bull markets, most stocks go up; in bear markets, most go down). In a “relative” system, meanwhile, a stock with a positive rating might actually be expected to drop in price. If the analyst expects the average stock in the industry to drop 70 percent, for example, and the particular stock to only drop 50 percent, then a “Buy” rating is appropriate—even though the stock’s value is expected to be cut in half.
The point is that the responsibilities of stock analysts, who cover only a single industry, are different than those of financial advisers, who make specific investment recommendations to specific clients. Single-word stock ratings, moreover, only convey a fraction of the information necessary for a particular investor to make a decision. Simplicity is great—investment decisions would be wonderfully easy if a few sages could just tell everyone what to do—but, alas, it’s also an (expensive) illusion.