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Small investors make the wrong bets
Research By: Soeren Hvidkjaer
If you are a retail investor and are wondering why
everyone except you is making money in the stock market,
Soeren Hvidkjaer, assistant professor of finance, may have
an explanation. Hvidkjaer is the author of “Small trades and
the cross-section of stock returns,” which shows that stocks
being sold by small investors tend to outperform stocks
being bought by small investors. Hvidkjaer’s paper will be
published in the Review of Financial Studies.
Hvidkjaer’s research shows that this difference in
performance lasts for as long as two to three years. “The
persistence of the results is very surprising,” says
Hvidkjaer. “The monthly returns are perhaps moderate but the
cumulative effect is very large. Basically, it seems that
stocks bought by small investors become overvalued, and in
the long-run these stocks return to their fundamental
values.” Hvidkjaer believes that these differences in
returns cannot be attributed to rational motives such as tax
considerations or private information because of the time
horizon over which the differences in returns persist.
Hvidkjaer also rules out risk. As the efficient market
hypothesis would suggest, the difference in returns may be
due to the difference in risk. Because it is extremely hard
to capture and correct for risk, Hvidkjaer adjusted his
results for characteristics which are commonly thought to
proxy for risk, such as size, book-to-market ratio, and
momentum. He found that adjusting for these characteristics
tends to dampen the difference in returns but stocks being
sold by small investors still tend to outperform stocks
being bought by small investors. Thus, these differences
cannot be attributed to risk. Hvidkjaer also tested this
finding across various methods and sub-samples, and found
the results to be robust.
To obtain the sample for this study, Hvidkjaer used all
ordinary common stocks listed on the NYSE and the American
Stock Exchange from January 1983 through December 2004.
Transaction data on NASDAQ stocks is only available from
January 1993 onwards, and Hvidkjaer included that too. He
then constructed a measure of the small investor’s sentiment
(‘buy’ or ‘sell’) about a stock called the signed small
trade turnover (SSTT).
Hvidkjaer isolated small-sized buying and selling
transactions. Using definitions specific to each firm, he
was able to differentiate the small-investor-initiated trade
from the large-investor-initiated trade. For the small
investor initiated trades, for each stock, sell-initiated
volume was subtracted from buy-initiated volume, and the
difference was divided by the number of shares outstanding.
This gave the SSTT for each stock. A high SSTT indicates a
‘buy’ sentiment whereas a low SSTT indicates a ‘sell’
sentiment. He then built portfolios on the basis of SSTT and
the results of the portfolio were measured up to 3 years in
the future. The results showed that stocks with low SSTT
outperform stocks with high SSTT. In other words, stocks
which were sold by small investors outperformed stocks that
were bought by small investors.
Aware that the results of his study could be heavily
influenced by the abnormal behavior among NASDAQ stocks in
the late 1990s and early 2000s, Hvidkjaer points out that
the results are valid not just for those years but for other
time periods too. Despite these robust results and findings,
Hvidkjaer believes that it will be very difficult for a
retail investor to implement an investment strategy based on
his paper. “This is because due to the increasing trend of
using computer algorithms to make trading decisions, even
large institutional orders are broken into smaller and
smaller sizes making it extremely difficult to identify a
small-investor initiated transaction from a large-investor
initiated one,” says Hvidkjaer. Going forward Hvidkjaer is
keen to study how large institutional investor initiated
trades may be distinguished from the small investor
initiated trade.
Although Hvidkjaer’s paper may not have resulted in an
easy trading strategy for the retail investor, it does make
a significant contribution to one of the most important
debates in the finance field: Are stock prices efficient?
Hvidkjaer’s work suggests that small investors tend to act
in a sub-rational fashion and they also influence prices.
Hvidkjaer says, “It is commonly believed that even if small
investors act sub-rationally, they don’t impact stock prices
because their trades cancel each other out. But my research
shows that their trades don’t always cancel each other out,
because different small investors behave similarly and that
they do seem to impact prices.” |
