DP6915 Individual Investors and Volatility

Author(s): Thierry Foucault, David Sraer, David Thesmar
Publication Date: July 2008
Keyword(s): Idiosyncratic volatility, Noise trading, Retail investors
JEL(s): G11, G12, G14
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6915

We test the hypothesis that individual investors contribute to the idiosyncratic volatility of stock returns because they act as noise traders. To this end, we consider a reform that makes short selling or buying on margin more expensive for retail investors relative to institutions, for a subset of French stocks. If retail investors are noise traders, theory implies that the volatility of stocks affected by the reform should decrease relative to other stocks. This prediction is borne out by the data. Moreover, around the reform, we observe a significant decrease in (i) the magnitude of returns reversals, and (ii) the Amihud ratio for the stocks affected by the reform relative to other stocks. We show that these findings are also consistent with models in which individual investors, acting as noise traders, are a source of volatility.