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In Times of Crisis, Small Investors Can Move Markets Due to Emotional Trading Says Finance Department Study

December 18, 2014
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In the wake of a market-wide crisis, such as the 9/11 terrorist attacks, trading by retail investors can move markets opposite to the trading by institutions. That is among the findings of a new study in the Journal of Financial and Quantitative Analysis, from the School’s finance department. The study, which looked at the reactions of more than 1,600 different securities in multiple asset classes, found that when the markets reopened six days after 9/11, stocks and closed-end funds (held more widely by small investors) declined substantially. This return pattern held even though institutional investors responded by providing liquidity and were net buyers, taking advantage of lower prices due to panicked retail selling.

“What is interesting here is that in normal market conditions, we believe institutional traders drive prices because of the sheer volume of their trading,” said Timothy Burch, associate professor of finance at the School and one of the researchers. “However, in the first trading week after 9/11, institutional investors were net buyers and yet prices fell substantially because of smaller investor panic, despite whatever stabilizing force larger, presumably more sophisticated traders provided,” said Burch who conducted the research with Department of Finance colleagues Douglas Emery and Michael Fuerst. “This held even in the largest capitalization stocks in which institutions usually play a more dominant trading role.”

In order to the study the behavior of retail investors, the researchers examined closed-end funds (CEFs) and small-cap stocks, which are held and traded more widely by smaller investors. To study the behavior of institutional investors, they looked at trading in large cap stocks, where institutions they play a more prominent role.  The analysis revealed that small investors aggressively sold after 9/11 while institutions were net buyers.

The researchers also found that the speed of price recoveries during the second and third trading weeks following 9/11 depended on the quality of the information environment, as assets with higher quality and more readily observable information about fundamental values recovered much sooner.

“The finding that post-9/11 price recoveries were stronger and faster in assets with better information environments is consistent with my prior research conducted on stock market bubbles,” Burch said. “In that paper we found that stocks with higher quality information environments due to greater analyst coverage experience much less overvaluation.  The consistent theme is that a higher quality information environment promotes price efficiency.” See news release.

Burch notes there are important policy implications to his findings. “In some markets, governments subsidize analyst coverage for smaller, retail-trader dominated stocks to which the financial analyst industry pays less attention. Whether to mitigate bubbles or to curb panic and speed price recoveries in a crisis period, similar policies that promote an improved information environment should improve price efficiency, especially for assets on which professional research is currently underprovided.”

The 9/11 findings also reinforce conventional wisdom that smaller investors should maintain a long-term perspective, and avoid the stock market if unprepared to withstand short-term volatility. Moreover, the findings suggest that all but the most disciplined investors are better off avoiding stocks which, due to a lack of reasonable institutional-trader presence, are more likely to experience the sharpest and most persistent declines when the occasional crisis hits.

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