Investor Sophistication and Asset Prices

We show that geographical variation in the level of investor sophistication influences local asset prices. Investors in less sophisticated regions exhibit stronger trading correlations, and correspondingly, the returns of firms headquartered in less sophisticated areas are more strongly correlated, especially when local economic conditions are unusually bad or good. Further, we show that local economic conditions have a greater ability to predict local stock returns in U.S. states with less sophisticated retail investors. This evidence of predictability is stronger in regions with strong local bias. A trading strategy that exploits the predictive ability of local economic indicators earns 5-7% higher risk-adjusted returns in U.S. regions with less sophisticated investors. These asset pricing results are driven by the sophistication of actual local investors, and not by the characteristics of the broader local population. Our results disappear when we use population-wide measures of sophistication. Collectively, these results provide evidence of investor sophistication-induced segmentation in U.S. capital markets.