Investors often rely on stock price estimates provided by financial analysts as a valuable tool for gauging a stock’s potential and making buy or sell decisions. The consensus price, which represents the average of individual analysts’ target prices, can seem enticing at first glance, especially when it’s high. However, recent research from Yale School of Management’s Thomas Steffen and Frank Zhang reveals an important cautionary insight: the accuracy of these consensus predictions is significantly influenced by the degree of dispersion, or variation, in analysts’ individual forecasts.
In their study, Steffen and Zhang highlight the critical role of dispersion, a factor that is not always apparent to the public. When analysts’ predictions are closely aligned (low dispersion), consensus target prices are generally reliable indicators of future stock returns. However, when there is high dispersion among analysts’ estimates, these consensus figures often fail to predict actual stock performance, and may even mislead investors.
The researchers’ analysis showed that stocks with high dispersion tend to underperform, with investors more likely to experience negative returns. This effect is particularly pronounced in stocks with high retail investor interest, where inflated target prices can misguide individual investors. In these cases, analysts may be reluctant to update their predictions in the wake of negative news, leading to an unrealistic consensus target that does not reflect deteriorating company fundamentals.
Using data from the Institutional Brokers’ Estimate System (IBES) from 1999 to 2020, the researchers measured the level of dispersion among analysts’ predictions and compared it to actual stock returns. They found that stocks characterized by high dispersion were often those where analysts were slow to incorporate negative information into their price targets. This delay in updating predictions may stem from analysts’ desire to maintain good relationships with the companies they cover, as pessimistic views could jeopardize future investment banking business opportunities or access to company management.
Steffen and Zhang’s findings suggest that retail investors should be cautious about blindly trusting consensus target prices, particularly when dispersion is high. In fact, the researchers propose that a hedging strategy based on dispersion could offer investors a more effective approach. By going long on stocks with low dispersion and expected high returns, and shorting stocks with high dispersion and predicted poor performance, investors could potentially earn an annual return of more than 11%.
However, such a strategy is difficult to implement in practice, as dispersion data is not readily accessible to the average investor. Financial websites like Yahoo Finance and MarketWatch do not display this information, and obtaining individual analysts’ target prices from various banks often requires expensive subscriptions.
Ideally, greater transparency would allow investors to access dispersion figures more easily, enabling them to better evaluate consensus price predictions and apply hedging strategies. Steffen suggests that policymakers could encourage financial platforms to display additional data, such as the composition of target prices, their freshness, and the timing of updates.
Until that happens, there are a few indicators that investors can use to gauge the level of dispersion. For example, when the range between the highest and lowest target prices for a stock is large, this often indicates high dispersion. A significant gap between the current stock price and the consensus target price may also suggest that dispersion is elevated.
Ultimately, Steffen and Zhang’s research sheds light on an often-overlooked factor in stock price predictions. Dispersion is a dynamic that could significantly influence the success or failure of an investment strategy, and it’s one that investors should be mindful of moving forward. “This paper helps to illuminate what we can learn by focusing on these less apparent parts of analyst outlooks,” Steffen concludes.
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