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Essays on individual investors

Daniel Tobias Dorn, 2003
Faculty Advisor: Gur Huberman


Asset prices are the main focus of financial economics. Trading volume receives much less attention. In fact, the motives of securities trading are poorly understood. Neglecting traders' motivations, however, undercuts our understanding of pricing, as prices are determined by traders. This dissertation aims to shed light on why individual investors trade, and whether their trading activity affects asset prices.

In a first step toward understanding why individual investors trade, the first chapter of the dissertation addresses the question “Who trades?” by characterizing a sample of over 1,000 retail clients at a German broker. Within the sample, personal attributes fail to explain much variation in sophistication inferred from actual investment decisions such as the tendency to take idiosyncratic risk and churn one's portfolio. The two exceptions are self-reported wealth and risk aversion; other things equal, wealthier and more risk-averse investors hold better diversified portfolios and churn their portfolios less.

The main chapter of the dissertation offers an affirmative answer to the question “Does sentiment drive the retail demand for Initial Public Offerings (IPOs)?”. Using daily records of IPO trades as well as a unique data set of pre-IPO trades made by individual investors, this chapter documents that individuals are willing to overpay for IPOs following periods of high returns in recent new issues, and for IPOs that are in the news. Expectations about asset values unwarranted by fundamentals are an important determinant of retail purchases of IPOs and appear to have a transitory effect on prices.

The closing chapter turns to the question “Do individual investors move together and thereby affect prices?”. Ultimately, the impact on prices and returns drives the interest in the actions of individual investors. Using daily transaction records for a sample of 30,000 clients at a German broker, this chapter documents a strong tendency to herd among the sample investors. Moreover, there is a robust positive correlation between net purchases by individuals and abnormal returns. It is argued that this correlation is unlikely due to mere return chasing; rather, the correlation is suggestive of buy pressure exerted by individual investors.

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