If you’re new to trading, you’re no doubt itching to put your money to work for you by building your portfolio as quickly as possible. Thing is, while there are plenty of publications, organizations and individual analysts who are happy to offer Buy/Sell/Hold ratings, following these ratings blindly is a terrific way to lose your principal...and lose your nerve before you ever make that one profitable trade.
The stock market is all but essential for most of us looking to create real wealth over the long term, but any investment in the stock market also comes with very real risks. That’s precisely why FINRA (the Financial Industry Regulatory Authority) was created.
Real Quick, What’s FINRA Again?
FINRA is a not-for-profit organization that’s authorized by Congress to protect US investors by ensuring the securities industry operates fairly. So they’re not technically part of the government, but an independent institution that operates by:
- Writing and enforcing rules governing the activities of securities firms and brokers
- Examining firms for compliance
- Fostering market transparency
- Educating Investors
Basically, FINRA exists to protect individual investors from the inherent brutality of Wall Street, and the wolves that lie within. And they generally do a commendable job, as is evidenced by their Guide to Understanding Analyst Recommendations.
FINRA points out that there are two key takeaways when it comes to analyst recommendations:
- Analysts’ ratings DO NOT have clear, standardized meanings throughout the industry.
- Analysts might have potential conflicts of interest that investors should be aware of.
You Say “Underperform,” I Say “Market Perform”...
In the chart above, you can see how FINRA has broken down the different terms analysts might use, and most notably, that the same terms might be utilized in entirely different (even contradictory) ways by various firms. Firm B might mark a stock as “Hold,” while Firm C might mark the exact same stock as a “Market Outperformer,” both of which might seem like a great sign to an inexperienced investor. In reality, though, this would be a stock that’s having very little impact on your portfolio at best, and actively losing you money at worst. At some firms, a “hold’ rating has essentially become a euphemism for “sell,” a potentially dangerous effect of another roadblock to effective securities analysis: Conflict of Interest.
It seems entirely logical that a financial analyst’s main obligation would be to their clients, i.e., the investing public. However, the reality is a bit more complicated than that. While some analysts are unaffiliated, making money by selling their research to investing institutions, banks and private investors, many are actually employed by the very institutions that they are supposedly impartially critiquing. Kind of like a sous chef reviewing the head chef’s bolognese.
FINRA lists some main conflicts to look out for, including:
- Investment Banking Relationships
- Analyst Compensation
- Brokerage Commissions
- Buy-Side Pressures
- Ownership Interests in a Company
However, they also note that despite these inevitable conflicts, there’s no reason to assume analysts are corrupt or biased. Many analysts are very skilled at analyzing a company with rigorous objectivity, despite any business or personal connections they might have at any particular institution.
Point being, it’s important to do a little research on an analyst before following their advice, perhaps even following their work and comparing it to other comparable analysts before taking any action based on their suggestions. You can find out more about analyst recommendations by consulting your broker, or even reading the work of some of our own expert analysts published on Equities. Remember: When it comes to investing your own money, there will always be an element of risk, but you can minimize it significantly simply by doing your own due diligence and heeding advice from those with a track record of financial success and unimpeachable ethics.
DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer