Financial markets operate on a simple principle that should surprise nobody: every participant follows their incentives. This fundamental truth applies equally to large institutional players and individual retail investors, according to Devina Mehra, founder of First Global and noted investment expert.
The Problem with Stock Recommendations
When large stock broking and research firms label stocks as 'buy' recommendations, investors should approach these ratings with healthy skepticism. Only between 1% and 7% of all stock ratings by research houses are marked 'sell' at any given time, with the overwhelming majority being 'buy' or 'hold' recommendations.
This statistical reality reveals the skewed nature of the game. If investors could simply purchase stocks with the highest number of 'buy' ratings, this strategy would typically result in portfolio underperformance. The reason lies in institutional imperatives where firms prioritize keeping clients and bosses happy rather than providing objective analysis.
Securities firms face clear conflicts of interest. They avoid negative ratings or 'sell' recommendations on companies from which they hope to secure investment banking business. Similarly, they won't issue sell ratings on stocks that represent major holdings for their fund clients.
The Herd Mentality in Market Analysis
Research analysts frequently move in herds, finding comfort and safety in consensus views rather than forming independent opinions. A striking example occurred with Amazon in 2001, when First Global stood virtually alone with a 'buy' rating while the stock traded below $15.
Remarkably, Wall Street had been positive on Amazon for years leading up to this period, then collectively turned negative, with many predicting the company's bankruptcy. If analysts had examined the financials objectively, they would have noticed Amazon was generating substantial cash flows for the first time and no longer faced bankruptcy risk.
The incentive structure in the research business encourages analysts to echo popular opinions rather than risk being wrong with independent analysis. This herd behavior protects careers but doesn't necessarily serve investors' best interests.
Investment Banking Realities
The situation with investment bankers managing IPOs reveals another layer of incentive-driven behavior. Investment bankers receive bonuses based solely on the number of deals completed and funds raised, with evaluation focused solely on their position in league tables.
No investment banker faces evaluation based on how a stock performs after its IPO. Their stated objective remains maximizing the issue price for the company, without pretense of business evaluation. This creates inherent conflicts between bankers' incentives and investor interests.
Additional incentives operate around IPOs. Investors who participated in venture capital rounds or IPO stages have vested interests in maintaining high stock prices, since price declines directly impact their net asset values. This explains why they might invest in subsequent rounds or purchase stock in secondary markets.
Who Bears Responsibility for Market Bubbles?
When financial bubbles burst globally, the search for villains typically focuses on large institutional players like banks and brokers. However, the 'common' speculator often escapes scrutiny, despite playing a significant role in market manias.
Whether examining small-firm IPOs, the NFT frenzy, historical Tulip Mania, or other market madness, ordinary people willingly participated, believing they had discovered shortcuts to wealth multiplication. This represents a willing suspension of disbelief rather than outright mis-selling in many cases.
People often invest substantial portions of their savings in 'flavor of the time' opportunities primarily driven by greed rather than sound financial justification. The incentive to achieve quick returns affects all market participants, not just institutional players.
As Charlie Munger famously stated, 'Show me the incentives and I'll show you the outcome.' This principle applies universally across financial markets, reminding investors to always consider the underlying motivations behind every recommendation and market action.
Devina Mehra emphasizes that while not every player in each category behaves identically, incentives inevitably influence behavior in most circumstances. Understanding these dynamics represents the first step toward making more informed investment decisions.
