Sensational News Days Drain Retail Stock Liquidity

On days of big sensational news stories that dominate broadcasts, many retail investors get distracted from trading, reducing liquidity in retail investor-owned shares.

Asia, Europe
24 October 2016

In a research paper by Joël Peress, INSEAD Professor of Finance and Daniel Schmidt, an Assistant Professor of Finance at HEC, “Glued to the TV: Distracted Retail Investors and Stock Market Liquidity”, the authors find a noticeable drop in the number of traders in US equity markets on sensational news days.

While retail traders have become less important over the past few years on average, they still hold a third of the U.S. market directly, which has implications for market liquidity when they are absent.

In their paper, the authors look at 532 “distraction days” between 1968 and 2013, such as the day OJ Simpson was found not guilty of murdering his wife and her friend, the aftermath of Hurricane Katrina and the first year anniversary of 9/11. They compare this with the trading activity of retail investors, liquidity and volatility in the market. The distraction events they measured were not based on the economy.

They define “distraction events” as days in which a single news story received an unusually large amount of airtime in evening news shows.

They find that such distraction events reduce traders in the market by between 6 and 7 percent, which is accounted for by the absence of small retail investors.

This effect saps liquidity in stocks predominantly owned by retail investors and leaves retail traders who remain in the market at the mercy of more informed institutional traders.

“As retail traders stop trading, other traders face higher costs and are at a higher risk of trading against someone who is more informed. This translates into losses for those investors who are not watching television because there are more sharks and fewer minnows in the pool on distraction days,” said Joël Peress, a Professor of Finance at INSEAD.

They also examined the differences between men and women traders. Previous research, in several fields, says men are more overconfident than women. They find that this overconfidence in males also makes them more prone to distraction, which ironically actually benefits them on distraction days as they stop trading. Female traders are not, which unfortunately works against them, because they stay in the pool with the sharks.

Institutional investors, whose trades outnumber retail trades, are not affected, nor are they distracted by sensational news, but remain focused on fundamentals. The authors find, therefore, that retail investors are better off when they don’t trade on these distraction days.

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