How Wise Are Crowds? Insights from Retail Orders and Stock Returns

Abstract

We analyze the role of retail investors in stock pricing using a database uniquely suited for this purpose. The data allow us to address selection bias concerns and to separately examine aggressive (market) and passive (limit) orders. Both aggressive and passive net buying positively predict firms' monthly stock returns with no evidence of return reversal. Only aggressive orders correctly predict firm news, including earnings surprises, suggesting they convey novel cash flow information. Only passive net buying follows negative returns, consistent with traders providing liquidity and benefitting from the reversal of transitory price movements. These actions contribute to market efficiency.

Keywords: market efficiency, retail investor behavior, return predictability, liquidity provision, financial news, private information

JEL Classification: G14