Individual investors, electronic trading and turnover

Academy of Accounting and Financial Studies Journal, May, 2006 by Vaughn S. Armstrong, Norman D. Gardner

ABSTRACT

We examine how changes in individual investors' cost for information and trading costs affect stock turnover, i.e., the portion of outstanding stock that trades during a specific period of time. We also test how individual investors with relatively short investment horizons affect turnover. We find that stock turnover increases when electronic trading becomes available to individual investors and that, while turnover is negatively correlated with individual investors' equity ownership, it is positively correlated with the level of electronic trading by individuals. This confirms the theory that investors trade relatively more actively when their costs of trading decline and provides further evidence that, when investors have the same trading costs and access to information, differences in their investment objectives leads to differences in their contribution to stock turnover.

INTRODUCTION

Not many years ago, it was widely predicted that the internet would transform business in very dramatic ways. Litan and Rivlin (2001) project that business cost savings due to internet use would add 0.2-0.4% to U.S. productivity. They did not attempt to quantify the effects of consumer gains due to greater convenience, wider product mix or enhancements in customization, or the productivity increases in the computer or software industries. Freund and Weinhold (2002) associate a 1.7% increase in the growth of U.S. exports of services with a 10% growth in internet use. Cooper, Dimitrov and Rau (2001) report that in 1998 and 1999 a corporate name change suggesting the company's business is internet related is sufficient to produce abnormal returns averaging in excess of 50%. While the bursting of the "tech bubble" may have tempered the expectations to some degree, there is little question that the internet has affected many aspects of business. This paper examines how reduced trading costs and improved access to information associated with electronic trading affects stock turnover, the portion of a company's stock that trades during a given period of time.

It is not surprising that mechanisms designed to reduce trading costs or enhance payment or settlement systems should affect financial markets. Financial institutions have long made use of electronic trading and payments systems and the advent of the internet likely had limited effect on these firms' trading. See, e.g. Greenspan (1996) and Flannery (1996). The difference the internet made in financial markets is in extending electronic trading opportunities to individual investors. This commenced with E Trade Financial Corp. (formerly E Trade Group Inc.). E Trade, formed in 1982, initially offered electronic brokerage services to securities firms, but in 1992, the company began offering electronic trading services directly to individuals through CompuServe and AOL. After going public in 1996, trading was even more widely available via the company's internet site. See Scripophily.com's E*Trade Certificate Vignette. Electronic trading through E Trade increased monotonically until the first quarter of 2000 when it peaked at nearly one quarter of a million trades per day, and has averaged about 120,000 trades per day since. Table 1 presents the average number of trades submitted daily through E Trade beginning in 1992. (The data is annual for 1992 through 1996 and quarterly thereafter.) Note that while initially E Trade was the sole electronic trading source, competing providers quickly appeared. As a result, later years' E Trade data indicates only a portion of total electronic trading. See, e.g., Laise and Mauldin (2005).

Availability of electronic trading reduces individual investors' trading costs and, at the same time, the internet improves individual access to information. These gave rise to a new type of trader, the "day trader", who pursued a trading strategy similar to that of a market professional, but without the benefit (or fixed cost) of exchange membership. We consider how stock turnover is affected by lower trading costs for individual investors, enhanced access to information, and individual investors' investment horizons. The literature suggests that these factors affect turnover but empirical studies have focused on institutional investors rather than individuals. The development of electronic trading permits us to investigate this additional facet of equity turnover.

Turnover increases when the market generates more information, Covrig and Ng (2004), and when investors' access to information improves, Pollock and Rindova (2004) and Karolyi (2004). Roewenhorst (1999) shows this result in emerging markets. Stock turnover is positively correlated with the standard deviation of returns and with firm beta, both of which are associated with volatility of information about the firm. Turnover is negatively correlated with firm size, consistent with the proposition that information about smaller firms is less accessible. In addition to the rate at which information is generated and the availability of information, the uniformity of interpretation of available information affects stock turnover. The more homogeneous investors' expectations are the lower turnover will be. Domowitz, Glen and Madhavan (2001) confirm the positive correlation between firm size and stock turnover in emerging markets, but find that the correlation is negative in developed markets. They suggest this result occurs because in developed markets intensity of analysts following of large firms leads to greater conformity in interpretation of information.