Sunday, February 15, 2015

Belief dispersion and trading volume

What causes trading to occur? The best answer is that there is a difference in opinion on the value of an asset. Differences in opinions will cause the market to have an abundance of both buyers and sellers and lead to trading as investors balance their portfolios based on their opinions. If there is no difference in opinion, there will be limited trading because there will be agreement about the value of an asset. Trading will pick-up once there is new information that enters the market, but the adjustment will be fast if there is agreement on what the information means. Portfolio rebalancing will occur on the way to the new equilibrium price. Differences in prior beliefs or differences in interpretation of new information drive trading.

Li and Li from the Fed's Board of Governors study this issue in their paper, "Are Household Investors Noise Traders? Evidence from Belief Dispersion and Stock Trading Volume". Using an extensive  database of consumer opinions, the authors are able to show the dispersion in beliefs about the macroeconomy by households. The dispersion is counter-cyclical. When we are in a recession there is a greater difference in opinions. The dispersion in opinion varies with professional forecasters.


The authors then find that the dispersion in opinion is correlated with more trading volume. Households act on those belief differences. This is not a new general result, but the focus on households is unique and the make up a significant portion of equity ownership. If you want to affect market expectations, it has to be focused on Main Street as well as Wall Street.

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