Analyst Reputation, Communication, and Information Acquisition

• Author: XIAOJING MENG
• DOI: http://doi.org/10.1111/1475-679X.12069
• Date: 01 March 2015
• Published date: 01 March 2015

DOI: 10.1111/1475-679X.12069

Journal of Accounting Research

Vol. 53 No. 1 March 2015

Printed in U.S.A.

Analyst Reputation,

Communication, and Information

Acquisition

XIAOJING MENG

∗

Received 20 February 2012; accepted 4 November 2014

ABSTRACT

Earlier studies have shown that reputational concerns tend to reduce agents’

opportunistic behavior. However, a recent study by Morris argued that an-

alysts’ (experts’) reputational concerns may discourage truthful communi-

cation when they try to avoid being perceived as being misaligned with

investors. In this paper, I examine the effect of reputational concerns on

communication in a setting where analysts can choose their precision en-

dogenously. Because both misaligned and aligned analysts want investors to

trust their reports in the future, both will aim to build a reputation for being

aligned. In equilibrium, aligned analysts will acquire more information than

misaligned analysts. As a result, investors may favorably update their beliefs

about the analysts’ type when the report is proven to be accurate. Therefore,

both types of analysts will have reputational incentives to communicate truth-

fully.The paper also derives conditions under which the analysts’ reputational

∗NYU Stern School of Business.

Accepted by Haresh Sapra. This paper is based on the first chapter of my disser-

tation at Columbia University. I am deeply indebted to Tim Baldenius for his contin-

uous guidance and encouragement on this project. I am also grateful to an anony-

mous referee, Edwige Cheynel, Wouter Dessein, Ilan Guttman, Marina Halac, Navin

Kartik, Volker Laux, Carolyn Levine, Tong Lu, Nahum Melumad, Beatrice Michaeli,

Alexander Nezlobin, Tiago Pinheiro, Yuan Zhang, and seminar participants at Berke-

ley, Columbia, CMU, Duke, Houston, NYU, Rutgers, Texas-Austin, Toronto, Wharton,

and Yale for their helpful comments and insights. All errors are my own. Finally,

I acknowledge the financial support from the Deloitte Doctoral Fellowship Foundation.

119

Copyright C, University of Chicago on behalf of the Accounting Research Center,2014

120 X.MENG

concerns have a nonmonotonic impact on aligned analysts’ equilibrium pre-

cision choices and investors’ welfare.

JEL codes: D83; M41

Keywords: cheap-talk; reputation; information acquisition

1. Introduction

In many situations, decision makers turn to experts for information and

advice. However, experts’ preferences or incentives are often not per-

fectly aligned with those of decision makers; hence experts may engage

in opportunistic reporting. Conventional wisdom and prior studies (e.g.,

Benabou and Laroque [1992]) suggest that experts’ future (reputational)

concerns are an effective way to discipline opportunistic reporting and

encourage truthful communication. The reason is that, if the aligned ex-

perts are committed to communicate truthfully, then to build reputation

for being aligned, the misaligned experts will also have reputational incen-

tives to communicate truthfully. One important implicit assumption here

is that the aligned experts are nonstrategic and always communicate truth-

fully.

A recent study by Morris (2001) has challenged the conventional wisdom

by endogenizing the aligned experts’ strategic communication behavior.

Specifically, Morris shows that, if the misaligned experts have a strong ten-

dency to issue a certain message, then, to build reputation, the aligned

experts will have an incentive to avoid sending this particular message,

which leads to information loss when the aligned experts are sufficiently

concerned about the future. Morris refers to this effect as “political correct-

ness.”

Morris’s finding is disturbing in that experts’ future concerns hurt com-

munication exactly in those cases where experts care about the future. One

of the important assumptions in Morris’s argument is that all types of ex-

perts are endowed with the same amount of information and don’t engage

in information gathering afterwards. Consequently, there is only one way to

build reputation for being aligned, which is to avoid sending the particular

message favored by the misaligned type.

In the real world, experts may engage in all kinds of information acqui-

sition activities. Therefore, the question left open by Morris (2001) is, in a

setting where experts can endogenously choose the precision of their infor-

mation, how do experts’ future concerns affect their communication with

decision makers? In this paper, I aim to answer this question, especially in

the case where experts’ future concerns are important, that is, when experts

care sufficiently about the future.

To model the reputation formation process, I build on Morris (2001)

and consider a repeated cheap talk game with two communication periods,

preceded by an information acquisition stage. In each period, the decision

maker makes a decision based on information strategically communicated

ANALYST REPUTATION,COMMUNICATION,&INFO ACQUISITION 121

by the expert. The decision maker is uncertain about the expert’s type. An

aligned expert internalizes the decision maker’s preference in each period

and always wants the decision maker to make the correct decision. A mis-

aligned expert, in contrast, always prefers the decision maker to choose a

higher action. The expert is endowed with some noisy private information

about the true state of the world. At the outset, the expert may engage

in (unobservable) costly information acquisition to increase the precision

of her signal for both periods. At the end of the first period, the decision

maker updates his belief about the expert’s type based on the expert’s first-

period report and the realized state; this updated belief about the expert’s

type is labeled “expert reputation.” The second period then unfolds simi-

larly, with a new state of the world. How much the expert values the second

period is interpreted as the expert’s “future (reputational) concerns.”

As a generic expert and decision-maker model, this paper can be applied

to various settings in which there are repeated interactions between an ex-

pert and a decision maker. In particular, the analyst setting is a natural

application. In practice, analysts may have investment banking incentives

or trading commission incentives, which lead analysts’ preferences to be

misaligned with those of investors. Unfortunately, investors usually don’t

have an exact idea about analysts’ preferences and can only rely on ana-

lysts’ track records to infer their type. Furthermore, an especially salient

feature of financial analysts is that they actively engage in various forms of

information acquisition. Therefore, this model is particularly descriptive of

the analyst setting and can shed some light on how analysts’ future con-

cerns affect their repeated strategic communication with investors in the

presence of information acquisition.

To demonstrate the main result, it is useful to first examine the commu-

nication game in the second period. Because this is the last period in the

model, the analyst does not care about maintaining her reputation. Conse-

quently, the aligned analyst will report truthfully, and the misaligned analyst

will issue a high report independent of her signal. Hence, if the investor re-

ceives a low report, he learns with certainty that the analyst is aligned. If

the investor receives a high report, analyst reputation (formed in the first

period) matters in that the greater the assessed likelihood that the analyst

is aligned, the more seriously the investor will take the analyst’s report and

invest accordingly. As a result, both types of analysts benefit from a high rep-

utation (along the equilibrium path). In addition, because the misaligned

analyst is more likely to exploit her reputation (she always issues a high re-

port in the second period), she benefits more from a high reputation than

does the aligned analyst.

Now consider the analyst’s incentives to acquire information. Note that,

in general, the analyst benefits from better information through two chan-

nels. First, better information increases the analyst’s ability to build reputa-

tion. I label this the “reputation effect.” Recall that the misaligned analyst

benefits from a high reputation even more than does the aligned one. Sec-

ond, better information enables the analyst to guide investors toward more