Are Retail Traders Compensated for Providing Liquidity?
Massachusetts Institute of Technology (MIT)
University of Rochester - Simon Business School; CEPR
David Alexandre Sraer
University of California, Berkeley; Princeton University
June 20, 2014
Journal of Financial Economics (JFE), Forthcoming
This paper examines the extent to which individual investors provide liquidity to the stock market, and whether they are compensated for doing so. We show that the ability of aggregate retail order imbalances, contrarian in nature, to predict short-term future returns is significantly enhanced during times of market stress, when market liquidity provisions decline. While a weekly rebalanced portfolio long in stocks purchased and short in stocks sold by retail investors delivers 19% annualized excess returns over a four factor model from 2002 to 2010, it delivers up to 40% annualized returns in periods of high uncertainty. Despite this high aggregate performance, individual investors do not reap the rewards from liquidity provision because (i) they experience a negative return on the day of their trade, and (ii) they reverse their trades long after the excess returns from liquidity provision are dissipated. During the financial crisis, French active retail stock traders stepped up to the plate, increased stock holdings, and provided liquidity. In contrast, mutual fund investors fled from delegation by selling their mutual funds.
Number of Pages in PDF File: 48
Keywords: retail investor behavior, return predictability, liquidity provision
JEL Classification: G14
Date posted: June 23, 2014 ; Last revised: October 14, 2015