What Determines the Holding Period of the Average Investor?
IN PRINT ARCHIVE CIR Fall 2000
|What Determines the Holding Period of an Investor?|
|This study examines the relationship between stock characteristics and the average holding period of an investor.|
|by Lawrence Kryzanowski and Bin Li|
In the security market, both individual investors and professional money managers make investment decisions on what and when to buy, sell or hold. An investor's investment performance is determined by the ability to correctly make these types of investment decisions. In this paper, we assess various potential determinants of average holding period behaviour for Toronto Stock Exchange (TSE) 300 stocks, using a measure of investor holding period behaviour that works for the thinner Canadian market.
Our findings should be helpful to investors interested in which stocks are likely to be more liquid because of their greater trading activity; to all market participants, because empirical research suggests that analyst following of stocks (and thus, information generation) is related to the relative level of trading activity1; and to clients of portfolio managers who follow a particular investment style, since investment styles and holding periods are related.
We examine the stocks in the TSE300 index from July of 1986 to June of 1996. We consider the beginning of July as the beginning of the studied year, and the end of June of the next year as the end of the studied year. Thus, each year runs from July of this year to June of the next year. The financial ratios for this year for a firm are taken from last year if the firm's fiscal year ended during the third and fourth quarters of the calendar year, and from this year if the firm's fiscal year ended during the first and second quarters of the calendar year.3
Due to the frequency of missing data for some of our determinants of the average holding period, we had to balance off the number of observations used with the number of determinants examined. To assess the robustness of our results to this choice and the impact of multicolinearity among the potential determinants, we ran nine combinations of possible determinants of the relative average holding period for our sample. The potential determinants are presented and described in Table 1.
The Determinants of Average Holding Periods
Determinants Based on the Relative Price
Studies in behavioral finance find that, when faced with a complex purchase, decision-makers tend to anchor on prices and prices changes as indicators of value. Decision-makers overweight more recent evidence, and over-rely on past trends when formulating future expectations. Being loss averse, investors tend to focus on negative information when under stress by overweighting the probability of negative events. They become more loss averse as downward price movements remind them of their incomplete personal control. Thus, behavioural finance suggests that the average holding period will be longer for growth compared to value stocks, or in-favour compared to out-of-favour stocks. We define value stocks as those with market-to-book values less than one, and growth stocks as those with price/earnings (P/E) ratios higher than a benchmark (for more details, see Table 1). In-favor (out-of-favor) stocks are defined as those with high (low) ratios of market-to-book values, P/E, price-to-cash-flow ratios and price-to-dividend yields.
We find that this year's average holding period for a stock is negatively related to whether or not it is a value stock this year. This suggests that a significant number of investors become overly pessimistic about value stocks, and that their selling activity causes the average holding period to shorten. We find that this year's average holding period is not negatively related to whether the stock was a value stock last year. If buyers or holders of last year's value stocks are value investors, they are expected to keep these value stocks longer. However, the results suggest that last year's value stock buyers and holders do not keep these stocks longer on average during this year. By buying growth stocks at relatively expensive prices (compared to earnings per share), growth investors hope to make an abnormal return through faster stock price growth. If true, rational growth investors are expected to keep growth stocks longer to realize their price appreciation expectations. As expected, we find that this year's average holding periods are longer for this year's growth stocks.
We find that this year's average holding periods become shorter for last year's growth stocks. A possible reason is that a large number of last year's growth stockholders sell their holdings during this year. Since the correlation between last and this year's growth stocks is only 0.411, another possible explanation is that continued high growth from one year to the next year is quite uncertain.
We find that this year's average holding periods are not related to last year's price-to-book ratios, this and last year's dividend yields, and this and last year's price-to-cash flow ratios. However, this year's average holding periods are negatively related with this year's earnings yields, and positively related to last year's earnings yields. Thus, the average investor tends to hold stocks that are in-favour this year for a shorter period of time.Determinants Based on Past Return Performance
Many papers document the continuation or reversal of stock returns over various periods of time. These U.S. studies find, for example, that momentum strategies which buy stocks that have performed well in the past and sell stocks that have performed poorly generate significant positive returns over three to 12 month holding periods.7 Over multi-year holding periods, other authors find a winner-loser effect, where winners (losers) in one multi-year period are losers (winners) over the subsequent multi-year period.8 The profitability of these momentum strategies is attributed to overreaction induced by positive feedback trading strategies.9 Momentum investors trade stocks based on the trend of return movements and not on fundamental information. "Trend-chasers" reinforce movements in stock prices even in the absence of fundamental information. If "trend-chasing" plays an important role in the performance of winners and losers, then the average holding period will be shorter for both winner stocks and loser stocks than for other stocks.
We find that this year's average holding periods are negatively related with this year's winners and with last year's losers. One possible reason is excess buying of winners and excess selling of losers by investors. These findings are consistent with 'trend-chasing' behaviour by investors. Thus, we find that both winners and losers are traded in Canadian markets. This differs from investor behaviour in U.S. markets where winners are traded and losers are held. We do not find that this year's average holding periods are positively related to this year's market-adjusted excess returns, and to last year's market-adjusted excess returns. Our findings do not support the hypothesis that the average investor prefers to hold stocks with good current or past return performances.Determinants Based on Trade Costs and Liquidity
Although brokerage commissions are material, the bid-ask spread represents the major part of trade costs. Theory suggests that investors who expect to hold a security longer (shorter) will own stocks with larger (smaller) bid-ask spreads.10 If this is true, then stocks with higher (lower) bid-ask spreads should have longer (shorter) average holding periods. We find that the average holding periods are positively related with spreads. This supports the notion that an average holding-period clientele effect exists based on the relative spreads of various stocks. Determinants Based on Risk
We use various proxies to measure risk; namely, standard deviation of returns, earnings and cash flow stability, number of years included in the TSE 300, debt/equity ratio, firm size and low price. While also can be a risk measure, we do not include it due to a lack of data for its estimation. The standard deviation is based on monthly returns over a one-year period. We use the Stock Guide definition of earnings stability, or the coefficient of determination, as a measure of how well earnings are related over a period of five or ten fiscal years depending upon data availability. This ratio gives some indication of the stability of earnings and the reliability of earnings growth. We use a similar definition for cash flow stability. We expect the debt/equity ratio to be positively correlated with the risk of common equity across firms.11
After controlling for differences in spreads and institutional trade activity, we expect larger firms to have longer holding periods. If we assume that low price stocks, defined as less than $5, are more risky, then such stocks will have shorter holding periods. Since firms with longer listing periods are allegedly less risky because they are more seasoned, we expect such firms to have longer holding periods. We use a similar logic for stocks that are included in the TSE 300.
We find no relationship between this year's average holding periods and the standard deviations of stock returns after accounting for factors like spread and size. As expected, we find a positive relationship between this year's average holding periods and this year's cash flow stabilities, and the number of years that firms have been included in the TSE300 index. We find no relationship between this year's average holding periods and this year's earnings stabilities or this year's debt/equity ratios or this year's low price stocks. As expected, we find a positive relationship between holding periods and size, after controlling for spread and institutional trade activity.Determinants Based on Stockholder Characteristics
Institutional investors play an increasingly important role in the security market. The allegedly short-term investment horizon of money managers causes them to trade more frequently than those individual investors who have long-term investment horizons. Thus, our expectation is that a stock with larger institutional investor ownership will have a shorter average holding period.
As expected, we find that this year's average holding periods are negatively related with the intensity of institutional trading activity (as measured by large share trades to total trades). This supports the belief that institutional investors trade more frequently than other investors.Conclusion
Our major findings are that the average holding periods (that is, the holding periods of the average investor) tend to be shorter for:
The findings of this study support the belief among market practitioners that an examination of the stock market must consider the strong possibility that investors are not fully rationale in their trade behavior.
Lawrence Kryzanowski is a professor in the Faculty of Commerce at Concordia University in Montreal, Québec. Bin Li is a consultant in Montreal, Quebec.