Cornell College Associate Professor of Finance Huan Cai puts cognitive psychology to use to better understand factors that impact financial forecasts in her latest research.
Cai, alongside Xiaodi Zhang and Jie Zheng, published an article, “Contrast effects: The phantom of an analyst’s latest earnings,” in the International Review of Finance.
The study uncovers a cognitive bias influencing professional financial analysts— called the contrast effect. That’s when one decision involuntarily shapes another due to information from a previous decision. Contrast effects are studied in psychology and cognitive science, but this paper reveals the impact on financial markets.
“We are among the first to show that cognitive biases exist based on analyst forecast results,” Cai said. “Financial analysts train themselves to be more objective, so we shouldn't discover any systematic biases in their forecasting, but we found in our paper that they actually do.”
The team of researchers analyzed decades of analyst earnings forecasts with a sample period that began in 1983. They found that an analyst’s recent forecast for one company can impact how accurately they predict another. In other words, good news about one firm can make another firm’s outlook seem less positive, and vice versa.
“So when they see extremely good news that happened yesterday for another company, and then when they try to focus on good news of the company they’re working on today, it may not look as good because of the previous one,” Cai said.
The trio of researchers also examined other factors. They learned that the closer the forecasts are issued, the stronger the impact of the contrast effect on the decision. Likewise, bias increased when analysts worked with firms in the same industry.
Why does this matter? Financial analysts influence how markets and investors make decisions. If their forecasts are biased, it can lead to distorted valuations—the estimated worth of a company—and poor investment choices.
“There are multiple implications from this research,” Cai said. “From the financial analyst’s perspective, this result shows that they are likely not aware that they’re making these types of biased decisions. That’s why they didn’t correct it. If they know, they can work to correct it. They need to make sure that their estimation is as accurate as possible.”
Cai says understanding bias is also helpful for explaining market decision-making to her students during the courses she teaches at Cornell College.
“Sometimes humans make mistakes,” Cai said. “Even the financial analysts make mistakes. What’s more important is: How do you learn from your mistakes? You don’t have to be the smartest in the financial market. If you understand what kind of biases other people make and trade accordingly, then you may be able to make a profit in the market.”
The study highlights how psychology shapes financial markets. Cai is excited to continue studying behavioral economics and hopes this research incentivizes others to take on similar studies in the future.
About Huan Cai:
Cai specializes in finance, with a particular interest in behavioral economics. She teaches Financial Accounting, Corporate Finance, Investments, Equity Valuation, and Investment Management Seminar at Cornell College in Iowa. Cai taught at Cornell from 2013 to 2017 and returned in 2022. Cai holds a doctorate in finance from the University of Utah in Salt Lake City. She also published a paper regarding another long-studied cognitive bias in psychology in the Journal of Behavioral Finance in November of 2022, “Confirmation bias in analysts’ response to consensus forecasts.”