Naïve is as Naïve does: The relation between retail investor attention, value investing, and noise

Abstract

This paper investigates whether noisy variables, such as price trends and market sentiment, attract more attention from these investors than value-related information such as the price-earnings (PE) ratio. The literature investigating the role of individual investors in stock markets has provided vast evidence of retail traders’ performance. In contrast, little scrutiny has been put into examining the factors that induce these investors to trade. The main motivation of this study is to provide evidence to answer this question. The evidence that value-investing information is more important to investment decisions than noisy parameters and that this importance is more acute when the stock market becomes cheaper indicates that retail traders commonly base their decision-making process on efficient information, which is incompatible with the understanding that these players make naïve investment decisions. The findings challenge the common assumption present in several noise trader frameworks that individual investors are natural candidates for naïve investors, aligning with a more recent strand of the literature documenting that retail investors make efficient investment decisions. I employ an ordinary least squares (OLS) model and a quantile regression approach. The dependent variable (investor attention) is proxied by Google search volume of online searches on different stock market indexes. The independent variables are market sentiment (based on the American Association of Individual Investors survey), market return and Robert Shiller’s cyclically adjusted PE (CAPE) ratio. The results suggest that PE dynamics are more important in explaining changes in attention than noisy variables. Moreover, the negative sign exhibited by the value-attention relationship indicates that individual investors are more (less) attentive to stocks when they become cheaper (more expensive). I also demonstrate that this association is more representative during down markets but absent during positive periods, contradicting the stylized fact that retail traders are a driving force of bubbles.