Yesterday, I wrote about how investors tend to invest in overvalued assets when they think other investors are optimistic about these assets. They are effectively trying to ride a wave of optimism even though they know this wave may not be grounded in fundamentals. The problem with this is that one has to be constantly on the lookout for signs the wave of optimism is breaking and then sell as quickly as possible. Hence, if investors tend to ride such a wave of optimism, one expects trading volume to increase as well as asset prices increase.
New research on trading volume and investor returns lends some credence to this hypothesis. Based on the share prices and trading data for all US stocks between 1964 and 2021, this research reaches the following conclusions:
Following a period of high share price returns, investors trade more in these stocks. This is an observation that has been widely known for some years, but what the new research found was that this effect also holds on different levels. A period of higher style returns or higher returns in the stock market overall leads to increased trading activity in individual stocks as well.
If market uncertainty is high, this effect becomes even stronger. Higher returns lead to even larger increases in trading volume if investors are uncertain about the future of the market.
The increase in trading volume following higher returns is not driven by a reduction in trading volume after poor returns. Rather, it is an almost entirely one-sided effect where trading volume increases after a period of higher returns but does not drop after a period of low returns.
Individual investors are more prone to this overtrading effect and they increase trading volume more than institutional investors in response to higher returns.
This is no proof that the hypothesis of investors riding a wave of optimism cynically is correct, but the patterns observed in trading activity confirm that investors tend to pay more attention to stocks after a period of high return and that they are sitting on a shorter fuse to get rid of the investment, particularly if they are uncertain the rally will continue. And that means in the end, that not only are there cynical bubbles in markets but there is also cynical liquidity.
Can you please better explain these two passages from your article:
"The increase in trading volume following higher returns is not driven by a reduction in trading volume after poor returns. Rather, it is an almost entirely one-sided effect where trading volume increases after a period of higher returns but does not drop after a period of low returns. [...] they are sitting on a shorter fuse to get rid of the investment, particularly if they are uncertain the rally will continue. And that means in the end, that not only are there cynical bubbles in markets but there is also cynical liquidity."
Does it mean that the volume is sustained by a cynical bubble in the same way as it is sustained by the exit of retailers who dump down their stocks, and vice versa?