Investor Sophistication and Asset Prices

Abstract

We show that geographical variation in the level of investor sophistication influences local asset prices. Investors in less sophisticated regions exhibit stronger trading correlations, and correspondingly, the returns of firms headquartered in less sophisticated areas are more strongly correlated. Further, we show that local economic conditions have a greater ability to predict local stock returns in U.S. states with less sophisticated retail investors. These asset pricing results are driven by the sophistication of actual local investors, and not by the characteristics of the broader local population.

Keywords: Local return predictability, return comovement, trading correlation, investor sophistication, risk sharing, local bias, state portfolios

JEL Classification: G11, G12