Resolving a Paradox: Retail Trades Positively Predict Returns but are Not Profitable

Abstract

Retail order imbalance positively predicts returns, but in aggregate retail investor trades lose money. Why? Order imbalance tests equally weight stocks, but retail purchases concentrate in stocks that subsequently underperform. Long-short strategies based on extreme quintiles of retail order imbalance earn annualized returns of -15.3% among stocks with heavy retail trading but earn 6.76% among other stocks. Our results reconcile the literatures on the performance of retail investors, the predictive content of retail order imbalance, and attention-induced trading and returns. We also find evidence that trades by retail investors with less knowledge, experience, and wealth are more likely to underperform.

Keywords: Individual Investors, Attention, Retail Trading, Return Predictability, Order Imbalance

JEL Classification: G11, G12, G14, G40, G41