Investor heterogeneity and stock returns: A generalized feedback trading model
This paper extends the dynamic (conditional) Capital Asset Pricing Model (CAPM) to incorporate the impact of three types of market participants namely, rational risk averse investors, positive feedback, or, momentum traders and negative feedback, or, contrarian traders on the prices of risky securities. The demand for risky assets on the part of rational risk averse investors is governed by risk/reward considerations along the lines of the CAPM. Positive feedback traders are essentially trend chasers, i.e., they buy risky assets when prices move up and they sell them when prices move down. This could be the result of irrationality, lack of information, or, portfolio insurance strategies that manifest themselves as momentum, or, positive feedback trading. Negative feedback traders follow contrarian trading strategies in an attempt to exploit trend chasers, i.e., they buy when prices move down and they sell when the prices move up. The interaction of the three types of investors leads to a complex time varying autocorrelation pattern for stock returns. There is evidence of both positive and negative feedback trading in small and medium capitalization portfolios. There is no evidence of either positive or, negative feedback trading in either large capitalization portfolios or the market portfolio. The actions of positive feedback traders increases covariant risk and the deviation of prices from equilibrium values.
Data
The data include daily returns for three size based portfolios (small, medium and large) as well as returns for the market index. All portfolios include NYSE, AMEX and NASDAQ firms and they are taken from the CRSP database. The sample period extends from 6/10/98 till 6/10/2013.
Preliminary Empirical Findings
The preliminary findings are rather interesting. First, there is a positive conditional risk premium at both the market and the individual asset level. Second, there is evidence of both positive and negative feedback trading in small and medium capitalization stocks. Third, there is not evidence of either positive or, negative feedback trading in large capitalization stocks. Finally, the actions of feedback traders (positive and negative) are not significant at the market level.