Investors' Horizons and the Amplification of Market Shocks
57 Pages Posted: 29 Nov 2010
Date Written: October 2010
After negative shocks, investors with short trading horizons are inclined or forced to sell their holdings to a larger extent than investors with longer trading horizons. This may amplify the effects of market-wide shocks on stock prices. We test the relevance of this mechanism by exploiting the negative shock caused by Lehman Brothers' bankruptcy in September 2008. Consistent with our conjecture, we find that short-term investors sell significantly more than long-term investors around and after the Lehman Brothers' bankruptcy. Most importantly, we show that stocks held by short- term institutional investors experience more severe price drops and larger price reversals than those held by long-term investors. Since they are obtained after controlling for the stocks' exposure to volatility, various firms' and investors' characteristics, including the momentum effect and the propensity of institutional investors to follow an index, our results cannot be explained by characteristics of the institutions' investment styles other than their investment horizons. We also show that the effect of shareholder trading horizon emerges during other large market declines. Overall, the empirical evidence strongly indicates that investors' short horizons amplify the effects of market-wide negative shocks.
Keywords: financial crisis, fire sales, institutional investors, investor horizon, market crashes
JEL Classification: G11, G12, G14, G18, G22
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