EC Why The Riskiest Stocks Have Been Vastly Outperforming Safe Ones

Factor table

The seven ranking systems I created for testing are all public. If you subscribe to Portfolio123, go to Advanced Research Search. In the Author box put “yuvaltaylor” and in the Ranking System Name box put “factors.”

How Could This Happen?

Some assessments of the impact that the Robinhood and wallstreetbets Reddit crowd have had on the market conclude that it’s pretty low. After all, the amount of money these investors have is absolutely dwarfed by the holdings of institutional investors.

But in the stock market, prices are driven not by how much money is invested, but by how many shares are being bought and sold. A $5 billion large-cap fund with 100 holdings that replaces a quarter of its holdings quarterly is going to have less impact on market prices than a $5 million small-cap investor with 20 holdings who replaces a quarter of her holdings daily.

How is that possible?

Scholars agree that market impact is roughly proportional to the square root of the ratio of the volume of shares the investor is trading to the total daily volume. So let’s call a unit of market impact MI. A typical small cap stock will have a daily dollar volume of $5 million while a typical large cap stock will have a daily dollar volume of $100 million. The $5 billion large-cap fund will make 100 trades a year of $50 million apiece. Each one will have a market impact of the square root of 0.5, or 0.71, for a total market impact of about 71 MI. The small-cap fund will make 1,000 trades a year of $250,000 apiece. Each one will have a market impact of the square root of 0.05, or 0.224, for a total market impact of 224 MI. So this hypothetical small investor with $5 million will have three times more impact on stock prices than the large-cap investor with $5 billion.

Michael Batnick recently published a good piece on this, from which I borrow the information that follows. According to the Financial Times, individual investors are now trading almost 25% of total volume, nearly as much as hedge funds and mutual funds combined (the bulk of trading continues to be done by high-frequency market makers). If we assume that they are trading in smaller stocks than hedge funds and mutual funds, they will have a much larger impact on prices. A recent paper looked at Robinhood traders alone, and estimated that despite having a market share of 0.2% in the second quarter of 2020, they accounted for 10% of the cross-sectional variation in stock returns. And then consider that the ratio of retail traders to institutional traders has grown significantly since then. There was, of course, a craze in “meme stock” trading that peaked on January 29, 2021, and retail trading has declined about 60% since then. But I don’t wish to prognosticate about what will happen over the next few quarters. All I want to say is that the ball game has changed.

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Alpha Stockman 1 month ago Member's comment

Great contrarian view.

William K. 1 month ago Member's comment

Quite interesting and certainly full of insight. The final evaluation that part of it is risk taken for the sake of risk is quite interesting indeed. That conclusion goes along with my assertion that at least part of the market movement is based on emotions. I do not say what kind because I don't know what is in people's heads. But clearly it is not fact based logic.

So it is nice to see that another has a similar opinion, approached from an entirely different direction.