Internet Search Intensity and Its Relation with Trading Activity and Stock Returns*

• Published date: 01 March 2021
• Author: Daniel Chai,Mengjia Dai,Philip Gharghori,Barbara Hong
• Date: 01 March 2021
• DOI: http://doi.org/10.1111/irfi.12268

Internet Search Intensity and Its

Relation with Trading Activity and

Stock Returns*

DANIEL CHAI,MENGJIA DAI,PHILIP GHARGHORI AND BARBARA HONG

Department of Banking and Finance, Monash Business School, Monash University,

Melbourne, Australia

ABSTRACT

Using Google search volume as a proxy for investor attention, this paper pro-

vides evidence on the role attention plays in financial markets. We first show

that abnormal Google search volume (ASVI) helps explain cross-sectional

variations in trading activity, even after controlling for its important determi-

nants. Specifically, ASVI is positively related to trading volume, order imbal-

ance and liquidity. When the relation between stock returns and ASVI is

examined, we find a strong positive relation in the month after attention

shocks and a reversal over a longer holding period. We further conjecture

that the attention effect is more pronounced in stocks with higher limits to

arbitrage. For this purpose, we construct a limits-to-arbitrage index and show

that limits to arbitrage play an important role in explaining the attention

effect.

JEL Codes: G3; G12

Accepted: 1 April 2019

I. INTRODUCTION

The efficient market hypothesis assumes that stock prices should instanta-

neously reflect new information as it arrives (Fama 1970). This assumption

requires investors to be aware of the full set of information available in the mar-

ket. However, psychological evidence suggests that investors can only handle a

certain amount of information at any point in time and thus, as Kahneman

(1973) has argued, attention is a scarce cognitive resource. The study by Barber

* We are grateful to conference participants at the World Finance Conference, seminar participants

at Macquarie University and especially to an anonymous referee and associate editor for helpful

comments.

© 2019 International Review of Finance Ltd. 2019

International Review of Finance, 21:1, 2021: pp. 282–311

DOI: 10.1111/irfi.12268

and Odean (2008) establishes the theory in investor attention. They argue that

investors face a search problem when selecting which stocks to buy. However,

the search problem is not as formidable when investors sell stocks, since they

can only sell the stocks that they already own.

1

Thus, when facing a search

problem, investors are more likely to buy rather than sell stocks that attract

their attention. This prediction leads to short-term positive price pressure at an

attention-grabbing event and this price pressure dissipates as attention wears

off over time.

The purpose of this paper is to examine the role attention plays in finan-

cial markets. We first hypothesize that attention helps explain the cross-

sectional variation in trading activity. Chordia et al. (2007) argue that trading

activity is a function of liquidity trading, the number of informed agents, the

degree of learning by investors on how asset returns are generated, and the

dispersion of agents’information signals. The authors further point out that

investors’liquidity needs are realized only in stocks that are more visible to

investors. Chordia et al. (2007) find that proxies for visibility such as size,

firm age, the book-to-market ratio, and price levels are important determi-

nants of cross-sectional variation in trading activity. Since attention is a nec-

essary condition for a firm to be publicly recognized, this should lead to a

positive relation between attention and trading activity in the cross

section when combined with the view that the buying behavior of investors

is influenced by attention-grabbing events.

In classical finance theories with a no-arbitrage argument, profitable oppor-

tunities from trading securities are exploited by arbitragers and their arbitrage

activities should correct mispriced securities. This argument is built on the

assumption that information is readily available to investors. However, arbi-

trage opportunities could become less obvious when information is sparse or

even ignored (e.g., Zhang 2006). Trade barriers such as transaction costs and

short-sale constraints could further hinder arbitrage activities. If the attention

effect is due to ignorance of price relevant information or to constraints in allo-

cating attention, the effect should be more pronounced in the presence of

severe limits to arbitrage. This is because investors who have a greater capacity

to obtain information and exploit mispricing will be more likely to avoid stocks

where arbitrage is difficult.

This paper employs monthly share price data drawn from the Australian

market from 2004 to 2015. Our proxy for investor attention is the Google sea-

rch volume index (SVI) following Da et al. (2011). The use of the Australian

1 One could argue that such a statement may not hold true for investors without short-sale

constraints, such as institutional investors. Indeed, as argued by Barber and Odean (2008),

unlike individual investors, institutional investors face search problems in both buying and

selling, even if they do not sell short. More importantly, the authors find that short-sale con-

straints do not fully explain their findings, since investors mostly sell stocks they

already own.

© 2019 International Review of Finance Ltd. 2019 283

Internet Search Intensity and Asset Pricing