Do Deviations from Investor Preferences Signal Informed Trading?

This paper provides a novel method for identifying informed institutional trading. I argue that, given an information signal about a stock, an investor’s tastes for certain characteristics of that stock can influence his decision to trade on the information. Thus, trades which deviate from an investor’s tastes are more likely to reflect information. I test this hypothesis with respect to investors’ taste for gambling (or more formally, for positive skewness), as proxied by local religious composition. Institutions located in areas with stronger gambling preferences allocate more portfolio weight to “lottery stocks” with high idiosyncratic skewness and volatility, hold more concentrated portfolios, and trade more, particularly among lottery stocks. The religionbased proxy thus captures predicted variation in trading behavior arising from the conjecture that investors’ tastes influence their decision to trade on information. Consistent with the main hypothesis, I find that the lottery stock holdings of institutions in the most gambling-averse areas outperform those of institutions in the most gambling-tolerant areas by 115 basis points per quarter, after adjusting for risk. The risk-adjusted return differential between lottery stocks purchased and those sold by more gambling-averse institutions is 215 basis points over the quarter following the trades, while the buy-sell return differential for stocks traded by more gambling-tolerant instititions is much smaller and statistically insignificant. This confirms the greater information content of lottery stock trades by investors who are relatively averse to gambling.