Retail Trading and Asset Prices: The Role of Changing Social Dynamics

Social-media-fueled retail trading poses new risk to institutional investors. This paper examines the origin and pricing of this new risk. I first present stylized facts on prices, quantities, and retail investors' beliefs for a set of meme stocks. I establish that aggregate fluctuations in retail sentiment originated from a growing and concentrated social network. The retail sentiment fluctuations induced changes in investor composition. As sentiment increased throughout 2020 and 2021, retail investors built up long positions, while price-sensitive long-only institutions have gradually exited the market since early 2020. Short interest stayed high in 2020, but dropped sharply following the price surge in January 2021 and remained low for the rest of the year. Motivated by these facts, I develop a model of the interaction between three groups of investors – retail investors, long-only institutions, and short sellers. I calibrate the model to match the price, quantity, and retail sentiment dynamics during this period. Then I use the calibrated model to demonstrate that social network dynamics shape the distribution of retail sentiment and have an economically large impact on asset prices. In the model, retail investors participate in a social network with concentrated linkages. This implies that their idiosyncratic sentiment shocks can lead to aggregate fluctuations in retail sentiment. Aggregate retail sentiment shocks shift investor composition, which in turn determines the price of retail sentiment risk. Following an increase in the aggregate retail sentiment, price-sensitive long-only institutions first hit their short-sale constraints, leading to a decrease in the aggregate demand elasticity in the market for an individual stock. Then a "small" positive retail sentiment shock can have a "large" price impact and even squeeze the short sellers.