Basic kinds of stock market investors

Terminology: Basic kinds of stock market investors

Investors ranging from the non-informed to the highly informed characterize the demand side of the stock market. The following describes four kinds of investor types: 1) The non-informed investors. 2) The medium informed investors. 3) The highly informed investors. 4) The perfectly informed investors. The first three investor types are present everyday in actual stock markets whereas the perfectly informed investor is a hypothetical construct that functions only as a point of reference.

The terminology is used in the following exhibitions about stock price theory

Exhibition: Why the equilibrium stock price is fluctuating
Exhibition: Why tough disclosure laws / rules decrease stock price fluctuations
Exhibition: Why excessively dispersed ownership increases stock price fluctuations
Exhibition: Private or public ownership - The effect on enterprise valuation

Non-informed investors

There are two kinds of non-informed investors: 1) Professional investors that have perfectly diversified portfolios. 2) Amateur investors that have non-diversified investments. Non-informed investors make no efforts at all to gather and analyze information about the fundamental value of the stock. Instead they rely exclusively on other and informed investors preventing the prices from diverting too much from the fundamental value. In other words, the non-informed investors free ride on the information about fundamental value that informed investors produces and indirectly make publicly available through their price determining market interactions. It is interesting that stock prices function not only to equilibrate demand and supply, but also to convey information about corporate value / long-term performance. When information is costless (as it is in perfect markets), prices function only to equilibrate demand and supply, because everybody knows the value of the goods they are buying. Non-informed investors typically prefer small stock holdings to large ones because minor holdings are more liquid.[1]

Medium informed investors

The medium informed investor analyze historical price or return information. Such analyses are also called technical analyses because investors use statistical- and econometric techniques to find out whether the historical price pattern exhibits any regularity. These regularities can be used to develop trading filter rules that may outperform an ordinary buy-and-hold strategy in terms of return before trading fees and salaries to the analysts. The finance literature typically refers to technical analyses in connection with the weak-form market efficiency hypothesis indicating that such analyses use only historical price information.[2] [3] Unfortunately, this indication is somewhat misleading. Principally, any information adding predictiveness to a technical model of the stock price may be used. However, typically technical analyses satisfy with the historical price information plus a limited set of publicly available statistics.[4] From a theoretical point of view it is interesting to note that if everybody in the stock market used only historical price information, the stock price would contain no information at all about fundamental value, and it would be completely random!

Highly informed investors

Highly informed investors analyze all publicly available information in order to estimate fundamental corporate value. This kind of analysis is called fundamental value analysis. As the name hints, the analysis tries to determine stock value by investigating the fundamental value drivers of the firm, such as quality of management, firm operations, organizational structure, industry specifics, and national regulation, more info here. Such analyses are conducted by using dividend models, equity models, cash flow models or some kind of combination of these models. In principal fundamental analysis may also include the use of insider information. Insider information is relevant information that is not publicly available.[5] Fundamental value analysis produces more certain stock price estimates than technical analysis but it also requires more time by the analysts. Another issue is that better-informed investors should be expected to have larger stock holdings than non-informed investors because this increases the return from being better informed. However, there are limits to this argument. For example, large holdings are less liquid and it is more difficult to trade without being discovered by other traders who try to mimic the trade of the informed traders in order to free ride on their information. Furthermore, some of the better informed investors are institutional investors, and the law probates that they own controlling stakes in the firms they invest in.

Perfectly informed investors

The perfectly informed investors invest 'as if' the cost of gathering and analyzing information were zero. This is a hypothetical situation, because it is very reasonably to believe that beyond a certain point the marginal cost of gathering and processing further information will simply be too high to justify the extra profit to be made from more certain estimates of fundamental corporate value. Fundamental value analysts are always able to improve their analysis by gathering more information and by examining it further. However, it does not pay because where as the costs principally may go indefinitely high, the gains are definite.

[1] The more likely it is to sell and buy stocks in a market without affecting the market price the more liquid the market is said to be. Naturally, the larger the quantity of stocks sold or bought, the less likely is it that the market price is unaffected. Confer Copeland and Weston [1988, page 370] for further information on the liquidity concept.

[2] According to the weak-form (capital) market efficiency hypothesis, the market is weak-form efficient if the market price fully reflects historical price information. The information is fully reflected when no investor can earn any excess return by devising an investment strategy that is based exclusively on historical price information.

[3] This indication may be seen at Malkiel [1987, page 120] or at Milgrom and Roberts [1992, page 467].

[4] For instance, Copeland and Weston [1988, page 385] report that a large American investment advisory service, The Value Line Investor Survey, uses four criteria in a filter rule ranking stocks according to what they predict is the most promising buy. The criteria are: 1) earnings and price rank, 2) a price momentum factor, 3) year-to-year relative change in quarterly earnings, and 4) an earnings ‘surprise’ factor. This is an example of a technical analysis using a limited set of public information.

[5] In finance theory, inside information is normally discussed in connection with the strong-form efficiency hypothesis. The argument is that if it is possible to make money on inside information the strong-form hypothesis is rejected. This is true, but it should not lead one to believe that inside information represents all relevant information. An insider typically only has a fraction of all the relevant information. However, that fraction may be just enough to determine the direction of the market price reaction at the time of publication although it may not be enough to determine the level of the impact.