In recent years a growing empirical literature has found that small investor trading behavior can cause market prices to significantly and systematically deviate from their fundamental values. Using a large database of retail investor trades, Kumar and Lee (2006) show that small investors tend to buy (or sell) stocks in concert. Such systematic retail trading explains return comovements for stocks that are particularly costly to arbitrage.
Hvidkjaer (2008) and Barber, Odean and Zhu (2009) show that stocks with intense small-trader buying pressure tend to be overpriced and go through prolonged under performance in the future. Andrade, Chang and Seasholes (2006) document that weekly changes in margin holdings from individual investors are positively correlated with contemporaneous returns and negatively correlated with subsequent returns. Barber and Odean (2007) find that for stocks with high retail trader concentration, the aggregate buy-sell imbalance of individual investors for the stocks is related contemporaneously to their returns.
While there is accumulating evidence that small investor trading behavior can affect equilibrium market prices, there is less agreement on the specific market frictions that permit such deviations from fundamentals to persist. Barber, Odean and Zhu (2009)argue that the ability of small trades to predict future return is the strongest for the stocks with greatest idiosyncratic volatility. Barber et al. (2009) reason that stocks with high levels of IV are more difficult to arbitrage. As a result, those stocks tend to experience greater mispricing and should have stronger subsequent price reversals.
However, following Schleifer and Vishny (1997) and Barberis and Thaler (2003) we observe that a variety of different limits to arbitrage can potentially simultaneously explain such price anomalies. In this paper, we therefore expand the empirical investigation of Barber et al. (2009) to whether the persistence of the excess return generated by small investor trading behavior can be explained by a set of leading limitsto-arbitrage in a multivariate framework.
We follow Barberis and Thaler (2003) and consider the following dimensions of limits to arbitrage: illiquidity, the presence of short-sales constraints and high idiosyncratic volatility (IV). Each of these three measures has been previously identified, empirically, as playing a role in forming a barrier to efficient markets.
By examining different market frictions simultaneously, we can learn significantly more about the relationships between the various limits to arbitrage and excess returns generated by small investors. In particular, this extension will allow us to ask which limit(s) to arbitrage are the best predictors of excess returns generated by small trades. For example, by examining the effects jointly, we might find that a stock’s liquidity is far more important than any short-sales constraints. In this sense, our empirical investigation can provide a deeper perspective of the sources of persistent mispricing.
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