Who Really Determines Stock Prices? The Surprising Influence of Retail Investors

At first glance, stock prices appear straightforward: earnings rise, valuations increase; earnings falter and valuations decline. Traditional finance theory suggests that prices reflect the collective wisdom of rational investors swiftly incorporating new information. Yet recent evidence challenges this tidy narrative, suggesting prices can be swayed significantly—sometimes dramatically—by the identities and behaviours of investors themselves, rather than purely by economic fundamentals.

Much of this fresh perspective emerges from Ralph Koijen, Motohiro Yogo, and Xavier Gabaix, whose research reshapes our understanding of what truly drives markets. Their central finding is that stock prices are astonishingly sensitive to investor demand, and notably, the influence of retail investors is far greater than most traditional models assume.

Standard Theory Versus Reality

Classic finance models typically assume that investor demand is highly elastic—meaning that when prices rise, investors quickly reduce their demand, and when prices fall, they readily buy more. Under this assumption, markets adjust efficiently to new trades with minimal disruption to prices. For instance, if you purchase 1 per cent of a stock, conventional theory predicts the price should rise by only around 0.02 per cent—essentially negligible (Koijen and Yogo 2020; Gabaix and Koijen 2021; Koijen 2022).

But empirical research consistently contradicts this view. Studies by Koijen and colleagues find that buying just 1 per cent of a stock actually causes its price to rise by roughly 1 per cent. In other words, investor demand is far more inelastic than standard models assume: prices must move substantially to accommodate even modest changes in demand. This remarkable disparity—a factor of around 5,000—means investor flows exert far greater influence on prices than theory predicts, significantly challenging the assumptions underpinning conventional asset pricing models (Koijen and Yogo 2020; Gabaix and Koijen 2021; Koijen 2022).

Who Is Moving Markets in 2025?

Koijen and Yogo categorise investors into three groups: large institutions (familiar names such as BlackRock or Vanguard), smaller institutional investors (such as hedge funds or boutique asset managers), and individual households (retail investors). Contrary to popular wisdom, their findings reveal that large institutions, despite holding around 70–80 per cent of total market capitalisation, have the smallest marginal influence on short-term price movements. This is because they typically hold broadly diversified, market-cap-weighted portfolios and trade relatively passively, limiting their immediate price impact.

Smaller institutional investors—hedge funds, active managers, and specialist investment houses—manage around 10–20 per cent of the market. Their portfolios are more concentrated and actively traded, resulting in significant market movements at a stock-specific or sector-specific level. Even more surprising, however, is the outsized role of individual investors. Retail investors, who account for roughly 10–20 per cent of market ownership and about 20–30 per cent of trading volume in 2025 (Kacaba 2025; U.S. Board of Governors of the Federal Reserve System 2025), drive substantial cross-sectional price volatility. Particularly during periods of market stress, excitement, or coordinated behaviour—such as the infamous GameStop rally—individual investors profoundly influence stock prices.

Koijen illustrates this clearly through analysis of the 2008 financial crisis, measuring how much each investor group contributes to differences in stock returns. Remarkably, he finds large institutions account for only about 6–7 per cent of the cross-sectional variation. Smaller institutions have a greater impact, explaining 26–42 per cent of variance, but individual households are responsible for the largest fraction by far, contributing 47–63 per cent (Koijen and Yogo 2020; Koijen 2022). This pattern intensifies post-2008, driven by the rise of zero-cost brokerage platforms, social media influence, and the availability of leveraged or fractional share investing.

Implications for Market Efficiency

Eugene Fama famously defines an efficient market as one where prices ‘fully reflect all available information’ (Fama 1970). Crucially, this doesn't imply prices are always fundamentally correct; rather, it means mispricings should be temporary, quickly corrected by rational investors.

Koijen’s work places this assumption under scrutiny. If small changes in investor demand—even seemingly irrational demand—can cause large and persistent price movements, market efficiency is clearly challenged. Retail investors, whose trading often hinges on sentiment, momentum, or herd behaviour, amplify these effects. Consequently, prices can detach from underlying fundamentals for prolonged periods. Arbitrageurs, theoretically tasked with correcting such deviations, frequently face practical limitations: capital constraints, short-selling restrictions, liquidity challenges, or risk management policies restricting their ability to fully offset irrational retail flows (Shleifer and Vishny 1997).

However, Koijen highlights an important caveat: even though significant mispricing exists, active traders and institutional arbitrageurs may still struggle to exploit it. The market's inelasticity is precisely why mispricing emerges in the first place—investors face real constraints that prevent them from quickly restoring rational prices (Koijen 2022). Thus, whilst inefficiencies are clear, systematically profiting from them remains exceptionally challenging.

These findings don’t necessarily render markets entirely inefficient; instead, the findings imply that they are noisier, less rational, and slower to self-correct than classical theory suggests. Short-term mispricings become frequent and pronounced, driven by investor behaviour rather than fundamental changes in dividends or earnings.

Practical Implications for Investors

What does this mean for investors? Firstly, it is clear that markets are influenced by sentiment. Therefore, investors focussing on fundamental analysis may find misaligned valuations for extended shorter-term periods.

Secondly, this environment rewards patience and discipline. If prices are driven away from fundamentals by sentiment, disciplined investors—those able to withstand short-term irrationality—may well benefit over the long term when prices become corrected.

Crucially, investors should acknowledge the risks inherent in attempting to capitalise on market inefficiencies. Persistent mispricing may continue far longer than investors can sustain their positions financially, echoing Keynes’ famous warning: ‘Markets can remain irrational longer than you can remain solvent.’ Thus, whilst acknowledging inefficiencies is critical, successfully exploiting them remains exceptionally challenging.

Conclusion: Efficiency Reconsidered

Ultimately, whilst markets remain broadly efficient in the long run, their short-term dynamics are increasingly influenced by investor behaviour—particularly that of retail and smaller institutional investors. Prices may be becoming noisier, more volatile, and frequently disconnected from traditional fundamental analysis.

Recognising this new reality helps investors set appropriate expectations. Yes, markets usually return to fundamentals eventually—but there appears to be ever more short-term price irrationality.

References

Fama, Eugene. 1970. ‘Efficient Capital Markets: A Review of Theory and Empirical Work.’ The Journal of Finance 25 (2): 383–417.

Gabaix, Xavier, and Ralph S. J. Koijen. 2021. ‘In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis.’ NBER Working Paper No. 28967.

Kacaba, Thomas. 2025. ‘How Retail Investors Will Reshape Public Markets in 2025.’ Crunchbase News, March 2025. https://news.crunchbase.com/public/retail-investors-reshape-markets-ipo-kacaba-dealmaker/

Koijen, Ralph S. J. 2022. ‘Prof. Ralph Koijen: Demand System Asset Pricing & Inelastic Markets’ Rational Reminder Podcast, Episode 212, podcast audio, July 21, 2022. https://rationalreminder.ca/podcast/212

Koijen, Ralph S. J., and Motohiro Yogo. 2020. ‘An Equilibrium Model of Institutional Demand and Asset Prices.’ Journal of Political Economy 128 (4): 1185–1248.

Shleifer, Andrei, and Robert W. Vishny. 1997. ‘The Limits of Arbitrage.’ Journal of Finance 52 (1): 35–55.

U.S. Board of Governors of the Federal Reserve System. 2025. ‘Households and Nonprofit Organizations; Directly and Indirectly Held Corporate Equities as a Percentage of Financial Assets; Assets, Level.’ FRED Series BOGZ1FL153064486Q. Last updated June 12, 2025. https://fred.stlouisfed.org/series/BOGZ1FL153064486Q