The Influence of Positive Feedback Trading on Return Autocorrelation: Evidence for the German Stock Market

Abstract

There can be no doubt that some investors try to discover trends in past stock prices and base their portfolio decisions on the expectation that these trends will persist. In the behavioral finance literature this type of investors is usually called a feedback trader. Positive feedback traders buy stocks in a rising market and sell stocks in a falling market, while negative feedback traders adhere to a “buy low, sell high” investment strategy. One of the consequences of the existence of a sufficiently large number of feedback traders in the stock market is the autocorrelation of returns and, hence, the partial predictability of aggregate stock returns. On the one hand, the behavioral finance literature provides a fair amount of theoretical models of feedback trading. Furthermore, the experimental findings and the survey evidence overwhelmingly support the existence of positive feedback traders.1 On the other hand, there is only a limited number of empirical investigations on the impact of feedback trading on stock price dynamics. According to these studies the empirical evidence is mixed with respect to the presence of feedback traders in stock markets and the resulting consequences for return behavior.