Recent growth in retail stock trading, made easier by apps such as Robinhood, raises important questions about the behavior of traders, according to this Harbert College researcher.
Although big exciting discoveries receive much attention, new research is typically incrementally built as a contrast to conventional wisdom or via new understanding of developments in the world at large. My interest in retail trading behavior is motivated from the latter.
Specifically, past decades have seen dramatic changes in how retail traders participated in stock markets. Decades ago, retail investors traded via phone while paying large commissions to brokers. More recently, online trading, competition among brokers and better market liquidity led to a decline in commissions. The culmination is the current zero-commission state of affairs led by the emergence of the Robinhood app in 2013.
Of course, as an empirical researcher, noticing that the world has changed is insufficient. To gain insights, I also need an empirical setting with data and testable hypotheses. As an empirical setting, I had already compiled data exploring an interesting contrast between overnight and intra-day stock return patterns.
Specifically, it is well established that riskier investments on average earn higher returns across a variety of asset classes. For example, more risky stocks earn higher returns than that of corporate bonds, and in turn these bonds earn higher returns than that of risk-free U.S. treasury debt. As a result, intuitively and empirically, we observe that a positive risk-return tradeoff is a bedrock of any investment decision by investors tolerating risk.
However, a puzzling finding has been that, among stocks, the more risky stocks actually earn equal or lower average returns than less risky ones, implying a flat or negative risk-return tradeoff.
Recently, however, researchers noticed that overnight stock returns actually do surprisingly show a positive risk-return tradeoff. Therefore, what is actually strange is the now more severely negative risk-return tradeoff during the day.
At this point, my interest in retail trading behavior was piqued because I can easily notice that one of the largest contrasts between overnight and intra-day trading is simply that retail traders are now awake. As a result, I can now think about whether the retail traders make puzzling and perhaps inefficient investment decisions.
Do retail traders underestimate risks in stocks? Do they prefer stocks with extremely large returns, as if they are gambling? Do they like to buy during certain times of the day, temporarily pressuring prices upward? And, importantly, has the increased participation of retail trading recently affected intra-day risk-return tradeoffs?
All of these questions are interesting, testable and give us clues into the behavior of financial markets.
Danny Qin
Assistant Professor
Department of Finance
