Don’t Follow the Trading Herd Over the Cliff

A large body of research has found that in both stock and bond markets, retail investors tend to be irrational, naive “noise traders” who display herdlike behavior, trading on sentiment rather than fundamentals. For example, in a series of papers (here, here, and here), Brad Barber and Terrance Odean demonstrated that retail investors are susceptible to behavioral biases such as overconfidence, often chase attention-grabbing stocks, and severely underperform the market due to active trading.

Further research shows (here, here, and here) that noise trading leads to mispricing, especially for hard-to-arbitrage stocks and during periods of high investor sentiment. Eventually, any mispricing would be expected to be corrected when the fundamentals are revealed, making investor sentiment a contrarian predictor of stock market returns. In fact, overpricing is more prevalent than underpricing because investors with the most optimistic views about a stock exert the greatest effect on the price; their views are not counterbalanced by the relatively less optimistic investors inclined to take no position if they view the stock as undervalued rather than a short position. Thus, when the most optimistic investors are too optimistic, the result is overpricing. Underpricing on sentiment is less likely.

Investor Overreaction

The authors of studies in 2023, 2021, 2020, and 2012 all found that the anomalies they examined were well explained by measures of investor attention, which were associated with the degree of mispricing. They also found that anomalies were stronger after high rather than low attention periods.

Too much attention allocated to irrelevant information triggers investor overreaction—the predictive power of aggregate investor attention for the stock market is derived from the reversal of temporary price pressures caused by net buying in high-sentiment stocks. The bottom line is that investor sentiment is a contrarian indicator, with high-attention stocks underperforming low-attention stocks.

An interesting question is: Do sophisticated investors exploit the frenzied, irrational buying of unsophisticated retail investors? Research into the information contained in short-selling activity has consistently found that short-sellers are informed investors who are skilled at processing information.

Frenzied Buyers

Dominique Outlaw, author of the study “Frenzied Buyers and Sophisticated Sellers: How Short Sellers Trade Individual Investors’ Most Purchased Stocks,” published in the September 2023 issue of the Journal of Behavioral and Experimental Finance, used a dataset of individual investors’ transactions to examine how short-sellers trade during periods of intense buying. She investigated whether the monthly short interest ratio—the number of shares at month’s end shorted divided by the total number of shares outstanding—is significantly higher for the top 20% of purchased stocks by individual investors in a given month relative to the other stocks individuals purchase during the month. Her data sample comprised individual investor stock trades from March 2008 to August 2011 in 25,131 accounts obtained from a U.S. full-service brokerage firm. The study spanned this period based on the availability of the individual investor data. Following is a summary of her key findings:

• About 23% of investors reported their risk tolerance as high, 75% as medium, and 2% as low.
• Only a small percentage invested for capital preservation or speculation (1.17%). Nearly 90% of investors reported their primary investment objective as growth, while about 11% reported income.
• After controlling for institutional ownership, short interest was significantly higher for stocks that were most purchased by individuals, including financial advisors’ purchases in their personal trading portfolios.
• The contemporaneous monthly short interest ratio was 6.6% for the lowest quintile of purchased stocks and 4.7% for the highest quintile. The difference of negative 1.9% was statistically significant at the 1% confidence level.
• When controlling for institutional ownership (a proxy for short-selling constraints), short interest was higher during the months of intense buying by individuals—when short-sellers were not constrained, individual investors and short-sellers displayed different outlooks on stocks’ future performance. The same held true for the stocks that were most purchased by financial advisors—the short interest ratio was higher for the most purchased stocks by financial advisors, although less intense when compared with those of individual investors.
• The six- and 12-month cumulative abnormal returns for the independently initiated purchases were negative 2.9% and negative 6.4%, respectively (statistically significant at the 1% level)—explaining why short-sellers targeted these stocks.

Outlaw concludes: “The findings of this study establish a correlation between high short selling around the most purchased stocks by individuals, including financial advisors whom individuals engage for their financial knowledge and sophistication.” She added that despite the brokerage firm financial advisors’ “expert knowledge,” their personal outlook may have been more in line with individual investors than sophisticated traders.

Investor Takeaways

The evidence demonstrates that the attention-induced behavior of individual investors leads to anomalies (mispricings). That is why retail investors are referred to as noise traders, while sophisticated institutional investors are referred to as informed traders. Sadly, individual investor trading driven by attention leads to poor returns.

Unfortunately for noise traders, not only do their behaviors tend to negatively affect their returns, but they also pay a price in terms of wasting efforts on nonproductive behaviors. Instead of engaging in attention-driven trading, they could be engaging in the more important things in life (such as family, friends, activities they enjoy). Helping investors learn this important lesson is one of the greatest value-adds a financial advisor can offer—some would argue it’s priceless.

The takeaway for investors is to avoid being a noise trader. Don’t get caught up in following the herd over the investment cliff. Stop paying attention to prognostications in the financial media. Most of all, have a well-developed, written investment plan. Develop the discipline to stick to it, rebalancing when needed and harvesting losses as opportunities present themselves.

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third party data and may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. The mentions of specific securities should not be construed as specific recommendations. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results. All investments involve risk, including loss of principal. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this information. LSR-23-548