The behavioral economics of earnings estimates

All you investor types might be interested in this.

Earnings season is upon us and pretty soon stocks will be gapping up or down based upon whether an extra penny was found or lost. That is, whether it was found or lost versus expectations.

How those expectations get formed is the subject of today’s observations, although we’ll only scratch the surface. Management guidance is the biggest anchor for estimates;…

Often what is easy to do in a situation like this is to think, “You know, if I use $1.45, I would be well above the high range. I’d still get credit for being right. There’s no sense being too aggressive on this.” And so begins a game of behavioral leapfrog. The other analysts covering the company will immediately notice the new number and think that they too should take another look….

All of this stems from our behavioral inclination to get comfortable with things as they are and to prefer small incremental changes rather than big ones.…The process of investing is full of similar traps. Take, for example, the movement in and out of a holding at an asset management firm, where the same principle applies. Just as the hardest thing for an analyst to do is to make a full conceptual reversal (as from being below consensus to being high on the Street, or moving from a “strong sell” rating to a “strong buy”), so too for a portfolio manager to go immediately from shorting a stock to buying it in size.

Because that is the case, we have a choice to make. We can adopt strategies that take advantage of the game of leapfrog that we observe, or we can do our homework and, if the time is right, get out ahead of the army of frogs by taking the biggest leap we can.

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