Unpublished Papers

Do Individual Investors Affect Share Price Accuracy? Some Preliminary Evidence

Alicia Davis Evans, University of Michigan Law School


Many believe that, in general, individual investors do not trade on the basis of fundamental information. They instead create “noise” and distort stock prices. Accurate share prices are, of course, important for economic functioning. Thus, some scholars have suggested that restricting market access for retail traders may be appropriate. In order to assess whether such regulation is warranted, however, more evidence is needed to determine whether individual investors, as a group, are indeed noise traders. This paper, employing a new data set on New York Stock Exchange retail trading and a widely used (yet controversial) metric of share price informedness and accuracy (the R2 of the regression of an individual firm’s stock return on the market return and the firm’s industry group return), contributes to the debate and provides evidence on the effect of individual investors on share price accuracy. Under the R2 methodology, lower R2's imply more accurate stock prices. The results from this study demonstrate that as the proportion of trading by individual investors increases, the R2 of firms decreases. The results of an instrumental variable estimation performed suggest that this relationship is a causal one (that is, the proportion of trading by individual investors causes changes in R2). Thus, if a low R2 is indeed a measure of share price accuracy and there is a causal relationship between retail investor trading and R2, the findings of this study provide evidence that, contrary to the received wisdom, increased trading by individual investors increases share price accuracy. Therefore, eliminating large numbers of individual investors from the market is unwarranted and potentially could be harmful to market efficiency. However, if the R2 methodology critics are correct and a low R2, rather than being a signal of share price accuracy, is instead a signal of informational inefficiency, then labeling individual investors, as a group, as noise traders may be justified.