When a nation is absorbed by a single sensational news story, what happens to the markets? One day that mesmerised the U.S. was the day that celebrity and former athlete O.J. Simpson was found not guilty of the murder of his ex-wife and her friend. The number of people who watched the news surged to the extent that telephone call volume declined, electricity consumption surged as viewers turned on television sets, and water usage plummeted as they postponed using bathrooms. There was also a noticeable drop in trading on Wall Street.
Individual investors are especially distracted – distracted to the point that many stop trading – on days where major news events are covered intensely on TV, which, in turn, drains liquidity.
Traders glued to the TV
In our paper “Glued to the TV: Distracted Retail Investors and Stock Market Liquidity”, we use these “distraction events” to study how retail traders affect stock market liquidity. Liquidity is one of the most important, yet poorly understood, aspects of financial markets. It represents the ease and cost with which investors can buy stocks on the market, which alters risks faced by traders.
Looking at transcripts from television news archives from 1968 to 2013, we found 532 days with distraction events that were not based on the economy. We identify these events as days in which a single news story received an unusually large amount of airtime in evening news shows. If these news events concerned the economy, even if they were the focus of major news coverage, they were removed from our study.
Some major distraction events include the Challenger space shuttle explosion, the verdict in the O.J. Simpson murder trial, the U.S. Senate confirmation of Supreme Court Justice Clarence Thomas, the funeral of Princess Diana and news on the aftermath of Hurricane Katrina. The 9/11 commemoration rather than day of the attacks was included in our top distraction events because the extensive coverage of the first anniversary, unlike 9/11, was not a story that affected the U.S. economy.
Why minnows matter
While retail traders have become less important over the past few years on average, they still hold a third of the U.S. market directly.
We found that on distraction event days, there is 6 to 7 percent average drop in the number of traders. As retail traders stop trading, other traders face higher costs and are at a higher risk of trading against someone who is more informed. This translates into losses for those investors who are not watching television because there are more sharks and fewer minnows in the pool on distraction days.
Our evidence shows that retail traders contribute to liquidity by acting as “noise traders” – those who trade without considering fundamental data about a security or firm – and even market makers in their own right. Their absence is mainly felt by other retail investors with spreads increasing in high-retail ownership stocks. Institutional investors, whose trades outnumber retail trades, are not affected, nor are they distracted by sensational news, but remain focused on fundamentals.
We find, therefore, that retail investors are better off when they don’t trade on these distraction days. Watching TV rather than trading, improves a retail investor’s bottom line.
In looking at retail investors, we also examined the differences between men and women traders. Previous research, in several fields, says men are more overconfident than women. We find that this overconfidence in males also makes them more prone to distraction, which ironically actually benefits them on distraction days as they stop trading. Female traders are not, which unfortunately works against them, because they stay in the pool with the sharks.
Distracted off the market
Although many of us now get our news from apps or websites, we found that the TV coverage still represents an effective tool to gauge sensational news stories that direct retail traders' attention away from the market. It has the added benefit of allowing us to collect distraction events in a consistent manner over a 45-year period.
Another distraction event could be on its way, depending on the results of the U.S. election on November 8th, and small traders might do well to watch television rather than trade that day.
Daniel Schmidt is an Assistant Professor of Finance at HEC Paris. He received his PhD in Finance from INSEAD.
Joel Peress is a Professor of Finance and The AXA Chaired Professor in Financial Market Risk at INSEAD.
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