Individual and Institutional Investor Behavior.

Abstract

The first chapter analyzes both the disposition effect and trading performance at the individual level to determine whether and how investors learn from their trading experience. The study finds that performance improves and the disposition effect declines as investors become more experienced, suggesting that investors learn by trading. A substantial part of this learning occurs when investors stop trading after learning about their poor ability rather than staying in the sample and improving their ability over time. By ignoring investor attrition, the existing literature significantly overestimates how quickly investors become better at trading. The learning estimates suggest that investors do not learn fast enough to prevent behavioral biases from affecting asset prices.

The second chapter examines the relation between price changes and the interaction of individual investors and financial institutions. I find significant support for the hypotheses that prices respond to the trading of financial institutions and that individual investors supply liquidity to meet the trading needs of institutions. In addition, when individuals trade with each other and prices move, institutions respond by trading to push prices toward previous levels. Taken together, the results indicate that institutional investors set prices.

In the third chapter, I develop a method for classifying individual investor trades as "informed" or "uninformed." The method relies on a simple economic argument, and the classification is necessarily coarse. Nevertheless, in two large datasets of individual investor trading from the United States and Finland, trades classified as informed earn much better returns than trades classified as uninformed. Informed trades have permanent price impact while uninformed trades do not. The results show that some individual investors are able to trade on private information, contradicting earlier papers that argue that individual investors consistently make poor decisions.