Small and large trader behavior: Reactions to information in financial markets

A growing body of work in finance and accounting highlights financial market "anomalies," showing that returns in financial markets are predictable in specific unexplained ways. Many papers have appealed to behavioral explanations for these anomalies. A key question is: How do we evaluate the effect of psychological or cognitive biases in the market? This thesis conditions on a proxy for investor sophistication and tests for differences in behavior with respect to this proxy. The particular proxy used is trade size, in terms of the dollar value of a trade. Using NYSE Trades and Quotations (TAQ) data we calculate daily measures of buy- and sell-pressure for a sample of over 2,700 NYSE securities, for the ten years from 1993 though 2002, for five trade-size categories. The data and approach are applied in three chapters.; "Small Trade Reactions to Consecutive Earnings Surprises" analyzes whether traders react more strongly as a series of similar earnings surprises continues, motivated by prior behavioral finance research. Results show that small traders exhibit a significantly increasing reaction as a series of similar earnings surprises continues, while large traders exhibit approximately the same reaction to each successive surprise. Returns results suggest that the small-trader increasing reaction is not motivated by returns patterns. "Small and Large Trades Around Earnings Announcements: Does Trading Behavior Explain Post-Earnings-Announcement Drift?" analyzes small and large trader behavior around earnings announcements, and for an extended period after the earnings announcement and examines the predictive ability of event-time trading behavior for returns.; "Are Investors Naive About Incentives?" co-authored with Ulrike Malmendier, analyzes whether stock market investors adjust for incentive conflicts in the setting of analyst buy-sell recommendations. We find that large traders react positively to a buy or strong-buy recommendation only if the analyst is unaffiliated. Small traders react positively after positive recommendations regardless of analyst affiliation. In addition, large traders exert significant selling pressure in response to hold recommendations, and no pressure in response to buy, while small traders exert zero pressure and significant buying pressure respectively. Our results imply that small investors do not account for the incentives of analysts to distort information.