According to previous research, individual investors
are very sensitive to market news and short-term
returns; they tend to sell when share prices rise and
buy when share prices fall. In addition, they trade against
earnings surprises, selling shares of companies that release
better than expected earnings news. In all these trades,
investors lose money. The fact that investors systematically
lose money contradicts theories of market efficiency.
In the study “The Limit Order Effect,” University of Chicago
Graduate School of Business professor Juhani Linnainmaa
analyzed how the use of limit orders alters previous assumptions
about investor behavior.
When individuals want to buy shares of stock, they can use
market orders or limit orders. A market order offers the benefit
of immediate purchase, though the investor is likely to pay a
higher price. If the investor wants to use a limit order, he or
she will set a cap on the highest price they are willing to pay
for a share as well as indicating when the limit order will
expire. In order for limit orders to execute, the market price
must fall to the limit order price.
“If you aren’t willing to pay the current market price for a
stock, you submit a limit order and wait until someone is willing
to sell,” explains Linnainmaa. “Since prices are constantly
changing, a limit order may get executed in five minutes, an
hour, a day, a month, or not at all.”
As Linnainmaa explains, there may be individual investors
who can afford to wait for a better price and opt to use limit
orders. If a company announces unexpected news, other
investors who monitor the market closely may submit market
orders to take advantage of the now stale limit orders (a limit
order becomes stale when there is news about the company).
The stale limit orders then execute. It will look as if limit
order traders reacted to the news by trading in the wrong
direction and losing money, with many individuals simultaneously
making the same mistake. This can lead to false
inferences about investors’ stock picking skills and timing.
A study that does not account for limit order investors’ passive reaction to news runs the risk of confusing the cause and effect of investor behavior. Linnainmaa calls this bias "the limit order effect." "The limit order effect suggests that many findings about investor behavior, including poor performance, can be explained as side effects of using limit orders," says Linnainmaa.
Linnainmaa combined individual investors’ trading
records with limit order data to examine the importance of
the limit order effect. He finds that stale limit orders signifi-cantly alter inferences about investor behavior. The limit
order effect may be a simple, yet powerful, explanation
for many findings about individual investors’ behavior
and performance.
“If investors use limit orders, they lose money when their
limit orders get executed in response to news in the market,”
says Linnainmaa. “In any trade that takes place, informed
investors will win. However, uninformed investors don’t
lose because they misinterpret information or because their
behavioral biases generate systematically bad trades; they
lose because they are uninformed.”
However, Linnainmaa notes, there is an upside to using
limit orders.
“It should be kept in mind that individuals may still be doing the right thing by using limit orders,” says Linnainmaa.
“If you use a market order, your immediate loss might be
greater than what you would expect to lose to the informed
investors if you submitted a limit order instead.”
The use of limit orders can lead to false conclusions about the performance of individual investors. It is the limit order traders who appear to possess poor stock picking skills and who seem to misinterpret new information.
Widespread Use of Limit Orders
To study the limit order effect, Linnainmaa used data from the
Helsinki Exchanges (HEX) from September 1998 to October
2001. Investor trading records were taken from all publicly
traded Finnish stocks from the Finnish Central Securities
Depository registry. Limit order data was obtained from the
supervisory files of the exchange. Using these two data sets, it
was possible to determine whether an investor used a market
order or a limit order in 60 percent of all transactions.
Linnainmaa’s findings are not specific to the Finnish market.
Data from the United States also indicates the widespread
use of limit orders. Using data from a U.S. discount broker,
Linnainmaa finds that nearly three-quarters of the orders
submitted by the individual investors in the United States are
limit orders. The magnitude of these numbers suggests that
limit orders are likely to alter inferences about investor
behavior in the United States.
Investor Behavior
Linnainmaa finds that limit orders significantly contribute
to irregularities in investor behavior. Traders with stale,
unmonitored limit orders appear to possess poor stock picking
skills and seem to misinterpret new information. In contrast,
market order traders earn positive returns when reacting to
new information.
Earnings announcements provide
a trading opportunity for investors
who closely monitor the market. If
an investor reacts to new information
before competitors, he or she can
profit from all the limit orders between
the current and post-announcement
valuations. An earnings announcement
renders all pre-announcement
limit orders stale. If individuals have
limit orders pending when the earnings
announcement arrives, only the orders going “against”
the news will execute.
Linnainmaa used data on earnings announcements
released during regular trading hours to determine whether
stale limit orders contributed to misinterpreting new information.
He computed average trading gains for all executed
orders around each announcement and found that the use of
limit orders entirely explains the tendency to trade against
firms’ earnings announcements.
Stale limit orders triggered after announcements performed very poorly and lost money. Individual investors who submitted
market orders immediately after announcements, however,
earned superior returns. These results contradict the perception
that individuals always misinterpret new information.
Individuals who make active decisions and submit market
orders are interpreting new information accurately.
“A stale limit order does not reflect current market information,”
notes Linnainmaa. “Ideally, investors should withdraw limit orders as soon as there are changes in the market,
but they rarely do. The problem is that individual investors
don’t have the resources to constantly monitor the market,
which places them at a disadvantage relative to institutional
investors.”
Previous research also has suggested that individual
investors consistently tilt their portfolios toward future losers
and away from future winners, which suggests poor stockpicking
skills. The stocks individual investors sell outperform
the stocks they purchase. Linnainmaa finds that the subsequent
performance of a trade depends on whether the individual
used a market order or a limit order.
Individuals displayed poor stock-picking skills only when
others traded against their limit orders. Market order traders
did not exhibit systematically poor timing. Hence, individual
investors do not lose money because they actively sell stocks
that go up in value and sell stocks that subsequently fall. It is
their passive behavior that generates the losses. Someone
with better information can tell which limit order traders
are offering to sell the stock at too low a price—or bidding
too much for it—and takes advantage of these uninformed
investors who find themselves on the wrong side of the
market when that information is publicly revealed.
How does limit order use affect inferences about individual
investors’ behavior? To address this question, Linnainmaa
studied several behavioral patterns. For example, the tendency
for investors to sell stocks with capital gains rather
than capital losses from their portfolios is referred to as“the disposition effect.”
Linnainmaa finds that limit orders significantly contribute to inferences about the disposition effect with almost half of the estimated disposition effect explained by limit orders.
Linnainmaa also studied how past stock returns affect
investors’ buying and selling decisions. Previous research has
suggested that investors follow “contrarian trading strategies.”
Limit orders are always contrarian, since they execute only
when the stock price moves against the order: a limit order to
sell executes when the price goes up while a limit order to buy
executes when the price declines.
Linnainmaa finds that limit orders account for all of the
short-term contrarian behavior and one-quarter of longterm
contrarian behavior. The lesson is that individual
investors are not necessarily “swimming against the current”
because their behavioral biases tell them to do so: their
decision to trade against past returns is a consequence of
their limit order use.
Support for Market Efficiency
“Finding that investors lose money because they are uninformed,
and not because they systematically make bad decisions,
is actually good news for those who believe in market efficiency,”
says Linnainmaa. “Underperformance is a result of individual
investors’ passive strategies—they lose money when new
information arrives because they often can’t withdraw their
limit orders in time. In the long run, limit order traders lose
because investors with more precise information trade
against them. Individual investors don’t have negative stockpicking
skills, they lose because they are uninformed.”
Linnainmaa also urges a degree of caution for investors:“When choosing whether to use a limit order, an investor needs to consider whether they think the order will execute because an impatient investor is willing to pay that price or if the limit order price is set so far below the market price that it can only execute if there is news. If I set the price too low, I can only lose: either the stock goes up and my order doesn’t execute, or the order executes because my limit order gets stale and someone takes advantage of it. Either way, I would just regret the order, so it would be better to set a higher price.”
“The Limit Order Effect.” Juhani Linnainmaa.