Are small investors naive about incentives?

Security analysts tend to bias stock recommendations upward, particularly if they are affiliated with the underwriter. We analyze how investors account for such distortions. Using the NYSE Trades and Quotations database, we find that large traders adjust their trading response downward. While they exert buy pressure following strong buy recommendations, they display no reaction to buy recommendations and selling pressure following hold recommendations. This “discounting” is even more pronounced when the analyst is affiliated with the underwriter. Small traders, instead, follow recommendations literally. They exert positive pressure following both buy and strong buy recommendations and zero pressure following hold recommendations. We discuss possible explanations for the differences in trading response, including information costs and investor naiveté.