Retail Investors, Behavioral Biases, and the Puzzles Shaking Up Asset Pricing

The rise of retail investors has upended traditional assumptions about market efficiency. Studies consistently show that retail traders are more speculative than institutional investors, often driven by behavioral biases rather than fundamentals. This speculative behavior helps explain several puzzling anomalies in asset pricing, particularly in consumer firms with high retail ownership. From irrational reactions to news to distorted belief updating, retail investors’ actions challenge the semi-strong form of market efficiency.

Behavioral Biases and the Puzzles They Create
Retail investors are prone to non-proportional belief updating, where they overreact to incremental information. For instance, a slight increase in the probability of an unlikely event is perceived as a much larger shift, fueling speculative trading. This aligns with Sadka’s finding of abnormal returns in the same month as news releases, even when no new fundamental data emerges. Similarly, the post-earnings announcement drift (PEAD) is amplified in retail-heavy stocks. Retail traders often misprice both cash flow implications and risk adjustments, creating sustained misalignments between price and value.

A Case Study in Irrationality
Consider the aftermath of news coverage about a pharmaceutical company. Trading volumes for both the company and the broader pharmaceutical sector surge, driving up prices despite no new information. This frenzy, followed by a correction weeks later, violates the semi-strong efficiency hypothesis, which assumes prices reflect all publicly available information. Instead, heightened information dissemination through social media hype or sensational headlines triggers herd behavior. Retail investors pile into stocks based on sentiment, not substance, creating bubbles that eventually deflate. This pattern underscores how news distribution, not just content, distorts markets.

The Post-COVID Retail Surge and Overvalued Markets
Since 2020, retail participation in equities has exploded, partly fueling stock market growth. However, this influx correlates with valuations drifting far above fundamental metrics. Retail investors, often influenced by social media and gamified trading platforms, chase momentum and meme stocks, ignoring traditional valuation models. Cross-sectional analysis reveals stark differences as sectors popular with retail traders  show higher volatility and disconnects from earnings, while institutional heavy sectors remain more stable. Over time, as retail ownership grows, these distortions intensify, raising questions about sustainability.

Diagnostic Expectations
The theory of diagnostic expectations where investors overreact to changes in beliefs explains many retail-driven anomalies. For example, if a biotech firm’s drug trial shows a 5% improved success rate, retail traders might behave as if the probability doubled. This bias amplifies price swings and creates feedback loops. These cycles are self-reinforcing until external shocks or institutional selling triggers a collapse.

The growing influence of retail investors demands a rethink of asset pricing models. Traditional frameworks struggle to account for biases like non-proportional updating or diagnostic expectations, which drive persistent mispricing. Regulators and policymakers face dual challenges of protecting retail investors from predatory practices while mitigating systemic risks from speculative bubbles. For academics, the cross-sectional variations in retail shareholding offer fertile ground to test behavioral theories.