Working Paper: CEPR ID: DP10285
Authors: Jeannol Barrot; Ron Kaniel; David Sraer
Abstract: This paper examines the extent to which individual investors provide liquidity to the stock market, and whether they are compensated for doing so.We show that the ability of aggregate retail order imbalances, contrarian in nature, to predict short-term future returns is significantly enhanced during times of market stress, when market liquidity provisions decline. While a weekly rebalanced portfolio long in stocks purchased and short in stocks sold by retail investors delivers 19% annualized excess returns over a four factor model from 2002 to 2010, it delivers up to 40% annualized returns in periods of high uncertainty. Despite this high aggregate performance, individual investors do not reap the rewards from liquidity provision because (i) they experience a negative return on the day of their trade, and (ii) they reverse their trades long after the excess returns from liquidity provision are dissipated.
Keywords: financial crisis; individual investor; liquidity; retail investor
JEL Codes: G10; G11; G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| retail traders provide liquidity to the market (D40) | stock returns (G12) |
| one standard deviation increase in daily retail order imbalances (C69) | stock returns (G12) |
| retail trading behavior (L81) | liquidity provision (E41) |
| individual investors experience negative returns on the day of trading (day 0) (G14) | do not benefit from excess returns (G19) |
| individual investors do not reverse their trades quickly enough (G14) | do not benefit from excess returns (G19) |
| experience (Y60) | ability of retail investors to effectively provide liquidity (G24) |
| experience (Y60) | performance relative to less experienced traders (G41) |