ESSAYS ON INVESTOR BEHAVIOR AND TRADING ACTIVITY

PETRI KYRÖLÄINEN

ACTA UNIVERSITATIS OULUENSIS

G Oeconomica 28

Academic dissertation

Copyright © 2007

Acta Univ. Oul. G 28, 2007

ISBN 978-951-42-8435-9 (Paperback)

ISBN 978-951-42-8436-6 (PDF)

http://herkules.oulu.fi/isbn9789514284366/

ISSN 1455-2647 (Printed)

ISSN 1796-2269 (Online)

http://herkules.oulu.fi/issn14552647/

OULU UNIVERSITY PRESS

OULU 2007

Kyröläinen, Petri, Essays on investor behavior and trading activity

Faculty of Economics and Business Administration, Department of Accounting and Finance,

University of Oulu, P.O.Box 4600, FI-90014 University of Oulu, Finland

Acta Univ. Oul. G 28, 2007

Oulu, Finland

Abstract

This thesis investigates a set of equity market phenomena associated with investors' trading activity, using a comprehensive Finnish Central Securities Depository (FCSD) database that records practically all trades by Finnish investors. This database enables us to classify a large number of heterogeneous investors using both economic and institutional characteristics.

The first essay classifies investors by trading activity. It analyzes trading styles of active and passive investors during the boom in technology stocks 1997-2000. We find that the herding tendency of active investors grew monotonically, year by year. Particularly large active investors used momentum and growth strategies. Moreover, buy pressures of active investors were positively related to contemporaneous daily returns. Passive investors, on the other hand, herd very strongly and their trading exhibited a contrarian style throughout the sample period.

The second essay focuses on the relation between day trading of individual investors and intraday stock price volatility. I find a strong positive relation between the individual investors' day trades and volatility for actively day traded stocks. This finding suggests that day trading tends to increase volatility and/or day traders tend to become more active on the days of high volatility.

The third essay tests the theoretical proposition of Amihud and Mendelson (1986) that investors hold assets with higher bid-ask spreads for longer periods. We measure holding periods of individual investors directly and find that they are positively related to spreads. The models control for a variety of other stock characteristics (e.g. value vs. growth orientation) and investors' attributes (e.g. gender) affecting holding periods.

The fourth essay studies how both individual and institutional investors with different levels of capital gains and losses react to earnings announcements. I find that both sign and magnitude of capital gains affect individual investors' abnormal trading volumes. Individual investors are less prone to sell when they are carrying loses rather than gains. Furthermore, they react less to earnings announcements when capital gains or losses are large (over 20%). Taken together these findings provide support for prospect theory. Institutional investors appear to be less affected by psychological factors underlying prospect theory.

Keywords: bid-ask spread, day trading, momentum trading, Prospect Theory, trading activity, volatility

Introduction

1.1 Background

Traditional neoclassical finance theory assumes a single representative investor who rationally sets asset prices. This rationality in the beliefs of the representative investor implies that markets are efficient in the sense that actual asset values coincide with their fundamental values. Furthermore, the lack of investor heterogeneity in the neoclassical framework implies no trading. The famous examples of the models built on the concept of rational representative investor are portfolio theory by Markowitz (1952) the capital asset pricing model by Sharpe (1964) and Lintner (1965), and capital structure theory by Modigliani and Miller (1958). In the late 1970s, however, asymmetric information models were introduced to the finance literature. These models typically contain two types of investors: informed and uninformed investors (or noise traders). The early examples of these models are Grossman (1976) and Holmström (1979). Although asymmetric information models provided some challenge for traditional finance theory, the neoclassical model with its representative investor remained, in the language of Kuhn (1970), as the dominant paradigm.

The mid-80s witnessed the gradual rise of the new paradigm – behavioral finance – in this young branch of science. The theoretical and experimental premises of behavioral finance were already laid down in the psychology literature in the 70s by Kahneman and Tversky (1972, 1973, 1979). The most prominent early behavioral finance applications included the work of Shefrin and Statman (1985), who applied the prospect theory of Kahneman and Tversky to explain the so-called diposition effect. Behavioral finance is characterized by investors’ limited ability to analyze information and systematic biases in their decision making. By the end of the millennium behavioral finance gathered more momentum: various theoretical models and multiple empirical papers were published in the leading finance journals. Behavioral finance was already competing for the status of leading paradigm in finance on par with neoclassical paradigm. But how about the representative investor? Did the behavioral finance literature recognize differences in behaviour and institutional characters of different types of investors? Mostly it did not.

The leading theoretical models of behavioral finance such as Daniel, Hirshleifer and  Subrahmanyam (1998) and Barberis, Shleifer and Vishny (1998) were built on the traditional premise of a representative investor. Empirical behavioral finance literature did not fare much better. In the absence of more comprehensive data sets, usually only a single investor group was analyzed at a time, such as a sample of mutual funds, or trades by the clients of a single brokerage firm. Although these studies made huge contributions to the knowledge of how investors actually behave, they lacked the overall picture of market dynamics when various investor groups behave in potentially different fashion.

1.2 Purpose of the dissertation

The purpose of this dissertation is to analyse a set of important equity market phenomena that are related to investors’ trading activity. The thesis consists of four empirical essays. These essays seek to answer the following research questions: How are the activity characteristics of investors related to trading strategies? Did active or passive investors  use destabilizing trading strategies during the boom in technology stocks? How is trading activity related to the volatility of stock prices? How is trading activity associated with transaction costs? Do capital gain positions affect selling activity following earnings announcements? Each essay makes its unique contributions which we describe more specifically in the review section of the essays.

We search contribution from extensive data covering practically all trades by Finnish investors. These data allow us to classify a wide range of heterogeneous investors using both institutional and economic characteristics. Two of the essays use an economic characterization as a basis for an investor classification. These classification criteria are: trading activity and level of capital gains. In addition, we also apply more traditional criteria, by sorting market participants as individual investors and institutional investors.

Our aim is to apply these investor classes to analyze various market phenomena, such as trading strategies and price impacts of active and passive investors during the boom in technology stocks at the turn of the millennium, relation between day trading and stock price volatility, impact of bid-ask spreads on the market equilibrium in terms of investment horizon, and information usage and trading strategies by investors with different levels of capital gains around earnings announcements.

We find a number of interesting empirical results. The first essay documents that active investors followed momentum and growth strategies during the boom in technology stocks. Herding of passive investors was very strong but remained constant during the sample period. Herding of active investors, on the other hand, show an increasing trend towards the peak of the technology stock bubble. The second essay finds that the day trading of individual investors is strongly associated with intraday volatility of stock prices. The third essay documents a strong positive relation between bid-ask spreads and individual investors’ holding periods. The fourth essay finds that individual investors holding large capital losses are less inclined to sell following earnings announcements than individuals in other capital gain classes. Furthermore, investors with the price of a holding close to the assumed reference point – the purchase price of a stock – appear to be more sensitive to corporate news than are those investors carrying a stock with a price further from the reference point.

The rest of the thesis is organized as follows. Section 2.1 explains from the methodological perspective why understanding investor behavior is an important endeavor. Section 2.2 characterizes the traditional neoclassical investor as a benchmark to which deviations in investor behavior can be compared. Sections 2.3 and 2.4 present theoretical background and earlier evidence related to momentum trading and herding and explain how they may be related to asset pricing bubbles. These trading patterns are then analyzed in the first empirical essay of this thesis in the context of the technology stock boom. Section 2.5 describes the prospect theory and mental accounting framework, which provide theoretical background for the essay studying the relation between capital gains and reaction to earnings announcements. Section 2.6 explains how investment horizons relate to transaction costs and volatility of stock prices, providing a background for the second and third essays. Section 3 briefly reviews the empirical essays. Finally, the original essays are presented at the end of the thesis.

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