Incentives drive each and every participant in all capital markets

Investors must note that everyone is motivated by self-interest whether we know the specifics or not

- DEVINA MEHRA

Charlie Munger famously said, 'Show me the incentives and I'll show you the outcome'. After my last column, 'The Great IPO Rush: Never go by the big names that have invested' (rb.gy/tb68zw), where I explained why big institutional names invest in some crazily-priced initial public offerings (IPOs), people asked me about other incentive-driven behaviour by financial market participants.

Let us start with stocks being recommended as 'buy'-rated by large stock broking and research firms and how much credence you should give such recommendations. The big names may lack either the competence or the integrity (or both) to give the right advice.

Surprised? They may not be capable of doing a good job of analysis or may not put enough effort in it. Alternatively, they may be pushing some agenda.

If that were not the case, you could blindly buy those stocks in the public market that have the highest number of 'buy' ratings at any point. In most cases, you will find this strategy will lead to your portfolio underperforming.

This is because large players have their own institutional imperatives where they are trying to keep either their internal or external consumers (meaning their bosses or clients) happy by saying what they want to hear.

Thus, securities firms will not say anything negative or have 'sell' ratings on companies from which they hope to get investment banking business. Also, they will not have 'sell' ratings on stocks that are major holdings of the funds that are their clients.