Stock Price Synchronicity, Crash Risk, and Institutional Investors (Digest Summary)

The authors study the relationship between stock price behavior and the type of investor holding a particular stock. They focus on the impact of various investor types on stock price synchronicity (as derived from the R² of an expanded market model regression) as well as on crash risk. They attempt to differentiate between institutional investors with significant and long-term holdings and transient investors who primarily focus on trading. Through data analysis, they find that R² and crash risk are negatively correlated with long-term institutional holdings and vice versa. This finding, the authors argue, is probably a result of closer monitoring by institutional investors, which reduces the ability of managers to conceal information or capture cash flows for their own benefit.

It is an established fact that high stock price synchronicity is a function of poor information availability as well as of the tendency of managers to capture firm cash flows for their own benefit. If a strong monitoring mechanism is in place, it reduces managers’ ability to conceal information and their ability to make suboptimal decisions for their own benefit rather than to manage risk for shareholders’ benefit. Institutional investors with a large holding have a vested interest in closely monitoring firms’ cash flows and even forcing managers to take timely corrective action. In contrast, investors with a trading strategy tend to liquidate stocks because of poor performance rather than to discipline managers. This focus on short-term gains gives undue powers to managers to capture cash flows for their own benefit, which results in a higher R².

The authors also study crash risk in stocks. They find a strong relationship between crash risk and holding pattern. If a stock is poorly monitored because of the behavior of transient investors with limited holdings, managers might withhold the flow of negative information about the firm’s performance to protect themselves from losing their jobs. But as the bad news accumulates, managers are eventually forced to share accumulated negative information with the market, which results in a stock crash. The presence of large institutional holdings and the accompanying close monitoring reduce managers’ ability to conceal negative news on cash flows, which reduces crash risk.

The sample is composed of all Compustat firms incorporated in the United States from 1987 through 2010. Institutional ownership data are derived from the Thomson Financial Institutional Holdings database. Financial firms and utility firms are excluded, resulting in a sample of 10,053 firms. Weekly returns are used to avoid problems associated with thinly traded stocks.

The estimated coefficients of stocks with either an increase in trading by transient institutional investors or a large percentage of such investors are 0.949 and 0.932, respectively. Both are significant at the 1% level, which implies that stock price synchronicity is positively related to both the trading and holding of transient institutional investors. In contrast, the holdings of dedicated institutions is found to be negatively related to stock price synchronicity; the estimated coefficient of stocks with a dedicated investor holding is −0.185.

The authors also examine the 2007–08 financial crisis. As expected, crash risk variables in financial stocks were significantly higher in the crisis period compared with during 1987–2010. But unlike in industrial stocks, no negative correlation exists between crash risk and institutional investors in financial stocks because of the complexity of monitoring financial institutions, even by large dedicated institutional investors, and perhaps because of investor complacency associated with reliance on regulators for such monitoring. Regulatory monitoring obviously had major shortcomings and resulted in a severe crash of financial sector stocks.

The authors raise a very pertinent point regarding the value of having a long-term, focused approach to investing instead of a trading mentality. They provide evidence of the efficacy of active monitoring and shareholder involvement in such key management decisions as acquisitions, accounting, and tax disclosures. The range of investing techniques is also known to firm managers, who may use them to their advantage if their firms are held primarily by investors with a trading mentality. The authors also validate the point of view of analysts who favor long-termism as the key to maximizing returns.