THE BEHAVIOR OF individuals has also complicated the Chinese stock market for institutional investors. Noise trading and herding of individuals can cause high volatility, so the government expanded the mutual funds industry to stabilize the market. Unfortunately, investors in mutual funds also tend to display the same short-term attitudes as individual stock market investors. Under “redemptive pressure” by fund investors, who will withdraw their backing if dissatisfied with performance, the funds are similarly exhibiting tendencies towards short-termism, herding and disposition effects.
In addition, high-churn trading makes it expensive for institutions to conduct normal arbitrage; that is, buy undervalued stock and sell overvalued stock. High-noise trading often pushes the price further away from the fundamental value, so it is not surprising that institutions sometimes find themselves chasing trends or riding bubbles.
When the Shanghai Composite Index hit the 5,000s in late 2007, a senior economist from a top investment bank stated: “I don’t think that this is a bubble and it will keep rising to 10,000.” Naive individuals were apparently encouraged to back the bubble to last longer, so institutions could leave in time with pockets full of cash.
Compared with institutions, individual investors are disadvantaged in terms of information and professional knowledge. They are also more vulnerable to deceptive practices and insider trading. For example, institutions could mislead individuals by spreading rumors or manipulating price change.
IN THE CURRENT ENVIRONMENT, many individuals are losing money in the stock market and are complaining loudly. But, many more are still willing to play, even though the game can be unfair and difficult. However, the simple fact is everyone is bullish about the possibility of their personal success and they have no sympathy for losers until they themselves become one. So, there is little empathy or solidarity between other individual investors, meaning there is no chance of them banding together to agitate for fairer trading.
Of course, some individuals do benefit from institutional trading, but this is not always legal. For instance, if you know which stock will be bought ahead of a large purchase by a fund, you can get in first. This is usually related to inside information and is known as “rat trading” in China.
When I was a doctoral student of finance, a college friend suggested at a party that I “should work for mutual funds and then we can work together to make money.” He meant rat trading, which is illegal and carries significant penalties. As I went on to become a university professor, I was of little value to him so we have since lost contact.
How prevalent such behavior is on the Chinese markets is impossible to gauge. But, in China as elsewhere, short-termism and utilitarianism can not only affect people’s attitude towards life, but also override inclinations to be rational investors.