Using Wall Street Analysts’ Recommendations Properly

Wall Street

Quite a few people pay attention to recommendations set by Wall Street analysts. These recommendations can be quite useful, but only when used properly.

Where a stock’s price is likely headed is a big question that all investors ask themselves, from the moment that they are considering buying a stock to when it comes time to considering closing out their position.

These decisions really need to be maintained all along the way, and not doing so properly is by far the biggest mistake investors make. Even the worst mistakes aren’t so bad if they are rectified properly, and this is where it all needs to start, to decide whether we even should have entered the position in the first place.

A good analogy would be with a trader who takes on a trade based upon a certain expectation, that the trade will continue to move in its current direction for instance. That’s actually the rationale behind all trades, even ones where we’re looking to pick a bottom or top, as we at least need some sort of reversal to make the timing of the entry make any sense at all.

Should the trade behave in a way that is not consistent with our expectation, this means that the trade is not valid based upon our criteria and it is time to go. When we reach this point, there is no room for debate actually, we’re expecting it to go up and it doesn’t and that is that.

This doesn’t mean that this is a simple process, as we’re going to have to define our criteria properly and also measure it in a way that is consistent with our plan. This is really all a game of probability, and good traders are able to assess their initial probability of success and then ensure that we stay in the green with it throughout the trade.

These are not decisions made once and for all, but occur every step of the way, with every bar on a chart. Along the way, there will be movements against us which in themselves do not impact our probabilities of success enough, which need to be recognized, as well as the actual signal, a breaking down of our position that does portend that the trade is no longer worth staying in.

Investors can learn a great deal from traders, and this is but one example, but a very important one. Almost all investors as well as those who advise them confine themselves to what we could call the investing niche and mindset, which is far less rigorous on the whole, which leads to an inferior understanding of what we are investing in as well as a lack of proper position management.

The Long-Term View Does Not Mean We Close Our Eyes to the Present

As far as managing our positions are concerned, while investors focus more on the long term than traders do, this does not mean that we are entitled or empowered to practice neglect or poor judgement. We still need to monitor our positions carefully, and compare them not just with how well they are performing according to our expectations, but also how they stack up against other investments of a similar nature such as other stocks, as well as with other asset classes such as bonds or cash.

The goal needs to be to do our best to have our money in what has the best expectation with us within our risk appetite. This does not mean seeking the best returns necessarily, only those which provide them in a manner that is both sensible and comfortable for us. This does mean though that we’re going to have to be making assessments along the way because there just isn’t any other way to know if we are still on track to achieve our goals and whether action is required or not to manage our portfolio and assets.

All of this does require at least some skill, and while it may look easy to figure out what to do when we look back upon an asset’s performance history on a chart, and sometimes it is, but often times the right action is not so clear cut. If we don’t have clear objectives or a clear plan though, it’s not even possible to positively influence our performance as we at least need a way to know right from wrong, otherwise we just have decision chaos and are leaving things entirely up to chance, which is never a good idea.

There are a lot of analysts out there, and these analysts weigh on the assets that they follow from time to time, providing us with a classification of their outlook, variations on the buy, hold, or sell motif. We don’t see many actual sell recommendations though and there is a huge bias toward buying and holding investments among these analysts, and we might only see a sell recommendation long after an asset has been torched.

The recommendations therefore aren’t to be taken at face value unless you are someone who just likes to cling to pretty much anything for pretty much any length of time, which is of course a terrible strategy but one that quite a few investors have chained themselves to. The reason why this is such a bad approach is that our goal needs to be to at least seek to help ourselves, and the time to take action to do so isn’t after we have suffered massive losses, it is instead to at least try to avoid them.

However, we can seek to interpret these recommendations, such as a neutral means that the outlook is so poor that we should instead be in more promising ones, and actually stick to the top-level ones, a strong buy or an overweight rating or whatever an analyst uses as their highest recommendation.

Analysts don’t always agree though, so we may need to either find one or more that stands out and pay attention to them, or use a consensus, and using a consensus is usually the best approach because it involves looking at all the opinions out there and finding common ground among them.

Using Analysts’ Recommendations in a Way That Makes Sense

If we just practice this, we will generally be ahead of the curve, compared at least to acting blindly as we tend to do without this sort of guidance. The key here though is to not to take these recommendations literally but to use them as a means of filtering out undesirable positions.

This requires that we take a common sense approach to this. If there are 10 stocks that we are following, 3 which are buys, 6 which are holds, and 1 which is a sell, we want to start by not being in the one that’s a sell of course. We also want to be out of the ones that are merely holds because why would we want to have our money in one of these when we can put it in a buy one instead?

You would think that this is the approach people would take, but few investors do this, and this can only be explained by a bias against selling. This bias is actually a very strong one among a very high percentage of investors. If we’re going to pay attention to and use these recommendations by analysts, we might as well do so in a sensible way rather than a foolish one.

Even though the reasons behind an analysts’ recommendation may be fairly out of touch with what really goes on in the stock market, meaning that the things they spend so much time looking at and analyzing may not have all that much to do with where a stock is heading right now depending on the circumstances, they can provide some insight into the relative value of stocks.

There are times when investing in stocks is just not a good idea at all, and when three quarters or even more of them are going down in price, it just doesn’t make much sense to be in the ones that are suffering and suffer along with them. This is the biggest part that is left out by these analysts, and although market conditions may play a small role in their judgements and predictions, it doesn’t play much of a role at all and these analysts tend to be so immersed in predicting future business results that they miss the fact that often times business results don’t count for much or even anything at times.

If all we did was stick to the top level recommendations of analysts, this would certainly be preferable to doing nothing, buying stocks with little or no analysis and just holding them, but we really need to take this a step further and apply the additional filter of whether the asset itself, stocks for instance, is a buy, hold, or sell. Perhaps our stock is among the top 20% of all stocks but if even those stocks, and in particular, ours, are headed the wrong way due to a market wave, this becomes a mistake.

We do need to keep in mind that the scope of their analysis is confined to company fundamentals, and these things do factor into stock prices a lot of the time, to some degree, but while this can provide us an edge in sorting through all the different stocks we could own, we still need to be in a time where being in stocks overall is a good idea. During a bear market, where almost all stocks are going down, what may have been a good bet during a bull market turns into a bad one more often than not, and bad bets need to be avoided.

The best approach to all this is to take top picks from analysts and then view their charts, to ensure that the optimism that they are seeing with their technical analysis is making its way into the charts. If the chart looks ugly, or lacks promise, this is another way we can separate the wheat from the chaff and this is perhaps the most important way to separate these things.

Should things turn sour, should these bullish business projections that analysts are finding for us lose their influence and we see our performance deteriorate in spite of it, charts are a simple and handy tool to discover this. Anyone who invests without looking at charts are investing with one eye and even that one eye can get pretty cloudy at times, especially when the tears start to flow and our vision really gets distorted.

While trading should always focus on charts exclusively, with the longer-term scope of investing, taking account of business performance can be useful as well, especially among those who whose charting skills aren’t very good. Even the best chartists look at these things when using charts to invest because it provides useful information that can have us honing in on the good stuff.

Even if we don’t really know that much about using charts to predict price patterns, it doesn’t take much skill to tell between the good-looking charts and the bad ones though, and if we can take the best of the street’s recommendations that also have good looking charts, we will be way ahead of the average investor and truly set ourselves up for better results.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.