Retail Investors and the Mispricing Puzzle

The article “Retail Investors and the Mispricing Puzzle” was originally published on Alpha Architect blog.

Institutional investors are frequently spoken of in the finance literature as “smart money” while retail investors are considered “noise traders” who suffer from a variety of behavioral biases and cognitive errors, and as less equipped to do meaningful research. Toomas Laarits and Marco Sammon, authors of June 2025 study “The Retail Habitat,” published in the October 2025 issue of the Journal of Financial Economics, investigated trading patterns among retail investors, specifically looking at stocks that are hard to value—those with significant intangible assets, long cash-flow durations, and a higher risk of pricing mistakes. Their analysis reveals a systematic pattern in which stocks attract retail trading and why this matters for markets.

What the Authors Examined

Laarits and Sammon set out to answer a fundamental question: Is there a consistent pattern in the types of stocks that retail investors prefer to trade? Using comprehensive data on retail trading activity, they examined whether retail investors cluster around certain types of stocks and, if so, what characteristics these stocks share.

The researchers analyzed stock-level data to measure the intensity of retail trading across different securities, carefully accounting for known biases in how retail trades are attributed. Their investigation went beyond simply identifying which stocks retail investors trade—they sought to understand the underlying economic characteristics that make certain stocks appealing to individual investors. Their data sample covers the period 2007-2023.

Key Findings

The study uncovered several striking patterns that paint a clear picture of the “retail habitat”:

1. Retail Investors Favor Hard-to-Value Stocks

The central finding is that retail investors consistently gravitate toward stocks that are inherently difficult to value. This preference is both large and persistent over time—roughly 90% of stocks in the top 20% of retail trading intensity at any given time remain in the top two quintiles of retail trading intensity 12 months later—creating distinct segments in the market based on trading intensity.

2. Specific Characteristics of Retail-Favored Stocks

Stocks with high retail trading intensity exhibit three key characteristics:

• Higher intangible capital: These companies have greater proportions of intangible assets like intellectual property, brand value, and human capital rather than physical assets.
• Longer duration cash flows: The expected cash flows from these companies extend further into the future, making valuation more uncertain.
• Greater likelihood of mispricing: These stocks have a higher probability of being incorrectly valued by the market.

3. Reduced Sensitivity to Fundamental Information

Most importantly, retail-favored stocks show less sensitivity to earnings announcements. When companies release earnings, stocks with high retail participation react less strongly to this fundamental information. Instead, these stocks are more sensitive to retail order imbalances—meaning their prices are driven more by retail buying and selling pressure than by traditional fundamental news. The result is that high retail stocks have more volatile announcement news and returns, with a standard deviation of standardized unexpected earnings that is almost three times as large for high retail stocks than low retail stocks. Interestingly, they also found both that the dispersion in analysts’ forecasts for high retail stocks is roughly five times as large as for low retail stocks, and that analyst price and earnings forecasts are less accurate among stocks heavily traded by retail investors.

4. Strategic Segmentation by Informed Traders

The holdings of large institutional investors are negatively related to retail trading intensity. The authors developed a theoretical model explaining why this segmentation occurs. Informed investors face a trade-off: they can benefit from hiding their trades within the “noise” of retail investor activity, but this comes at a cost because producing information about hard-to-value stocks is more expensive and uncertain.

5. Mispricing of Retail Stocks

High retail stocks carry higher mispricing scores constructed by Robert Stambaugh and Yu Yuan in their 2017 study “Mispricing Factors.”

Key Takeaways for Investors

• Higher retail trading intensity often signals that a stock is harder to value and might not reliably respond to financial news, meaning standard fundamental analysis could be less effective.
• Stocks with more retail activity could be riskier or more mispriced, but also may offer unique opportunities for investors able to navigate uncertainty and behavioral flows.
• Sophisticated institutional investors may avoid the stocks retail investors favor because their prices are not as impacted by fundamental information, leading to mispricing. The result is that informed traders tend to concentrate efforts elsewhere. For example, institutional investors understand that hard-to-value stocks have volatile and idiosyncratic earnings day returns and, thus, want to avoid this risk. Investors should be aware that not all price movements in these stocks stem from underlying fundamentals.

Summary

“The Retail Habitat” provides compelling evidence on why some stocks, especially those popular with retail investors, may diverge sharply from traditional valuation models and pose special challenges—or opportunities—for savvy investors (while noting that limits to arbitrage such as the high cost and risks of shorting can allow mispricings to persist).

Larry Swedroe is the author or co-author of 18 books on investing, including his latest Enrich Your Future. He is also a consultant to RIAs as an educator on investment strategies.