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Investors Chronicle

Listen to the volumes

January 30, 2003

ISSN. 0261-3115

LENGTH: 490 words

What makes people trade stocks? Elementary as this question seems, it gets little attention. This is odd because trading volumes can vary enormously. Last year, the number of FTSE 100 shares changing hands in non-holiday weeks varied between 5bn and 12.5bn. This suggests a major influence on investors behaviour changes significantly. Should we really ignore this? No. New research by Steven Huddart of Pennsylvania State University shows why. He has found that trading volumes increase sharply when share prices are close to their 12-month highs.

Although his findings are based on US stocks over the past 20 years, the same appears true of UK stocks now. In the first full week of this month, there were 10 FTSE 350 stocks within 5 per cent of their 12 month highs. For these 10, trading volumes were, on average, twice those of the previous 52 weeks. Volumes for the other stocks in the FTSE 350 were up by an average of just 20 per cent. And there are many cases where a rising price triggers rising volumes. This appears to have happened often to Rio Tinto in the past three years.

Theres a good reason for this pattern, says Mr Huddart. It lies in prospect theory, an idea about attitudes to risk developed by the Nobel prize-winning psychologist Daniel Kahneman.

This says people take risks to avoid losses, but are keen to avoid risks once they have made a profit. In other words, they will hold on to loss-making stocks- thus taking risk - in the hope of an upturn. But they'll be quick to sell winners. The upshot is that trading volumes will be high when a stock is at the top of a past trading range, as investors cash in their gains. But theyll be lowwhen shares are at the bottom of this range, as investors will be reluctant to sell.

All this has important implications. It means theres a good reason why momentum investing - buying past winners and selling past losers - should work. If investors are reluctant to sell losers, prices will under-react to bad news. And if they're quick to sell winning stocks, prices will also under-react to good news, as such news will unleash pent-up selling pressure. Chartists arent talking complete rubbish when they speak of resistance levels.

This explains why momentum investing should work better for selling stocks than buying ones. The reluctance to sell losers is widespread, but the readiness to sell on good news applies only to a subset of stocks - those close to previous highs where investors can book profits. Selling losers thus makes more sense than buying winners.

What's more, this explanation for changes in trading volumes shows that investors can be irrational. There is, after all, no rational reason to sell stocks when they are near their 12-month high. This increases the credibility of behavioural finance explanations for share price moves. And it means we should think a little more before we trade: do we really always do so for good reasons?

Copyright 2003 Financial Times Business Limited

Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 863-0048
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