Connecting School Ties and Stock Recommendations

School connections are an important yet underexplored way in which private information is revealed in prices in financial markets. As HBS professor Lauren H. Cohen and colleagues discovered, school ties between equity analysts and top management of public companies led analysts to earn returns of up to 5.4 percent on their stock recommendations. Cohen explains more in our Q&A.
by Martha Lagace

Social networks matter for more than just efficient Internet communication. They're also crucial for the strong performance of stock recommendations by analysts, according to researchers at Harvard Business School and the University of Chicago Graduate School of Business.

As the researchers found, social networks in the form of school ties—bonds formed based on attendance at a common educational institution—helped equity analysts outperform on stock recommendations when the analysts enjoyed an educational link with a company's public management.

Harvard Business School's Lauren Cohen and Christopher J. Malloy, along with University of Chicago colleague Andrea Frazzini, investigated the ties between more than 1,800 sell-side analysts and the management of public firms, and the subsequent performance of stock recommendations. Although popular wisdom might suggest that Ivy League ties would come out strong, in fact ties from non–Ivy League schools were just as powerful, the researchers learned.

They detail the results and implications in an HBS working paper, "Sell Side School Ties" [PDF].

"Our findings suggest that agents in financial markets can gain informational advantages through their social networks," Cohen and colleagues write. "In addition, laws designed to block these types of information pathways can be effective in curbing selective disclosure. The magnitude of our results indicates that informal information networks are an important, yet underemphasized channel through which private information gets revealed in prices.

"Identifying the types of information transferred across social networks, and the extent to which social networks are important in other information environments, can provide us with a richer understanding of information flow, and price evolution, in security markets."

Cohen explained more in an e-mail interview with HBS Working Knowledge.

Martha Lagace: What made you think that there might be an interesting link between educational background and information advantages?

A: We had been thinking about the influence of social networks for a while. We noticed that every time we met people at conferences, an immediate starting point in conversations was to ask where one went to school. Educational connections seemed to be the first way people tried to bond or connect with each other. Whenever we met other people who went to the University of Chicago (where Chris and I received our Ph.D.'s ), we seemed to have a topic of conversation with our shared experiences there. We suspected this was likely to be the case in financial markets as well.

Q: How did you go about investigating your hypothesis? How did you select the 1,800+ analysts to study?

A: We had an idea that social networks may be important in situations where information transfer is important. Financial markets, in particular, are well-suited for this, as information is an obvious driver of security prices, with a large premium placed on information acquisition and synthesis. Certain agents play key roles in revealing information into equity markets. A large part of an equity analyst's job is to research, produce, and then disclose reports forecasting aspects of companies' future prospects, making them good candidates. From there we hand-collected past education of analysts and matched these to past education of board members and senior officers of firms. These 1,800+ analysts represent those from the entire universe of analysts from 1990 to 2006 on which we could find education data.

To test the hypothesis, we then examined the performance of analysts on stocks to which they had school ties relative to those they did not. For example, a Harvard analyst would have a school tie to a firm that has a Harvard CEO, but no school tie to a firm where all of the senior officers attended Yale.

Q: Did the results surprise you?

A: The fact that school ties seemed to be important in the data did not surprise us, but the magnitude of our results did.

Q: Why does information transfer more easily in a social network based on schools? What makes school ties different for this analysis from, say, family ties, community ties, or fraternity or sorority ties?

A: Our hypothesis is on the importance of social networks, with school attended being one example that we focus on. We believe people do take pride and identify with their alma mater, and in support of this, educational institutions are the second-largest recipient of individuals' charitable giving in the United States. Further, unlike corporate boards where directors are appointed and leave, school attended is a network that doesn't change over a person's life (after graduation). In addition, a person's school attended is data that we were able to reliably collect on a large fraction of financial market participants.

However, we do believe a number of other social networks, such as family or community ties, are also important for individuals, but we were unable to collect data on these.

Q: As you found, it wasn't necessarily Ivy League ties that were particularly meaningful, but rather school ties in general. Did these schools have especially active alumni affairs organizations, or were perhaps these ties assumed to be self-made among former students?

A: We can definitely say that the effect is there even when you remove Ivy League schools. We haven't tested if it is stronger for schools with more active alumni groups, but that is certainly a viable hypothesis. We should test it!

Q: What do you foresee as some implications of your investigation, perhaps in terms of hiring preferences?

A: One implication from our work that we tend to focus on is the importance of understanding social networks' impacts on many aspects of our lives. People seem to associate "social networks" solely with popular Internet sites. We believe social networks are incredibly important for a range of economic outcomes that affect all of our daily lives: from MBA students' access to certain jobs, to finding a good mechanic, to the information transfer in financial markets that we document. We hope our study encourages other researchers and practitioners to think more deeply about how social networks affect many things in their environments.

Q: What are you working on next?

A: More work on corporate boards. We have a new project where we show that sell-side analysts who end up on the boards of certain firms after their career as an analyst ends tend to have been overly optimistic on those stocks back when they were analysts.

About the Author

Martha Lagace is senior editor of Working Knowledge.