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.”