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Individual investors: Leaders or followers?

Retail and individual investors have long been a subject of underestimation as far as their role in stock market is concerned. It’s only in recent times when researchers began investigating retail investors’ role in determining the direction of market. A significant deal of recent research studies has dealt with this emerging issue in applied finance area. Borrowing theories and evidences from diverse areas such as economics, sociology and psychology, a new thrust area of applied finance called behavioural finance has emerged, and this tends to focus on the behavioural aspects of interactions between stock market participants.

Individual and retail investors are said to be more influenced by behavioural biases such as herding, overconfidence, and reinforcement bias etc., compared to their institutional counterparts. They are said to have made trading decisions based on psychological phenomena rather than on rational issues. So, can we say that these retail and individual investors are only the followers who buy such stocks that are on the rise, or they are the leaders that determine the direction of trades?

A recent survey of individual investors across Delhi-NCR (India) region show that they ARE making their trading decisions under the influence of several behavioural biases such and underconfidence, conservatism, and prudence. They trade on asymmetric information. But, how important is their role in determining the direction of the market?

Recent researches suggest that individual and retail investors are able to predict stock market movements better than the institutional ones. Pual Tetlock of Columbia Business School and Eric Kelley of University of Arizona (Kelley and Tetlock, 2010) analyzed the 5-year data on retail trade orders, representing 225 million executed trades and $2.6 trillion in volume, to explain how it is that retail traders regularly predict stock price movements. The private information hypothesis says that retail investors trade on information that others are not aware of, and that a stock’s price will take some time to reflect all available information. It turned out aggressive buying – market orders from retail traders to immediately buy regardless of price – usually precedes positive movements in stock prices. It can be said that retail and individual traders are buying in advance of price increases and selling in advance of price decreases.

Supporting the findings of Eric and Tetlock (2010), we found in a study of Indian individual investors that individual investors trading volume is a good predictor of stock price movements in Indian stock market as well. We run a causal study between individual investors’ trading volume and stock returns, and found that trading volume by individual investors with small lag value is able to predict stock returns in short term; for mid-to-long term, the effectiveness of this relationship gets reduced. So, we can say that individual investors trading volume acts as a significant predictor of stock returns in Indian stock markets as well; also that the role of individual and small investors in determining the direction cannot be ignored.

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