How Competitive is the Stock Market? Theory, Evidence from Portfolios, and Implications for the Rise of Passive Investing
59 Pages Posted: 7 Apr 2021 Last revised: 15 Aug 2022
Date Written: April 7, 2021
We develop a framework to theoretically and empirically analyze how investors compete with each other in financial markets. In the classic view that markets are fiercely competitive, if a group of investors changes its behavior, other investors adjust their strategies such that nothing happens to prices. We propose a demand system with a flexible degree of strategic response and estimate it for institutional investors in the U.S. stock market. Investors react to the behavior of others in the market: when less aggressive traders surround an investor, she trades more aggressively. However, this strategic reaction is not nearly as strong as the classic view. Our estimates suggest that when a group of investors changes its behavior, the response of other investors only counteracts half of the direct impact. This result implies that the rise in passive investing over the last 20 years has led to substantially more inelastic aggregate demand curves for individual stocks by about 15%.
Keywords: Asset pricing model, Demand system, Institutional investors, Liquidity, Information, Portfolio choice
JEL Classification: G1, G2, D4, L1
Suggested Citation: Suggested Citation