What your investor friend is not telling you

Households’ savings decisions — the types of financial instruments they use, whether they invest or not in stocks — often look similar to those of their neighbors. Social interactions allow for information dissemination about technologies, products, and beliefs. In social settings, however, individuals are selective about the information they want to share with others. For example, people may tend to boast about good stock trades (their latest most successful investment), or they may try to convince others that they are wealthier or more intelligent than what they really are. When negative experiences are filtered out to present a positive self-view to others, social interactions might favor the transmission of appealing but inaccurate ideas about financial decision making. Although selective communication in social networks has long been documented in psychology and sociology, the extent of its effects on investment choices remains largely unexplored.

In a recent study (Escobar and Pedraza, 2019), we use a natural experiment involving in a high-stakes environment to examine how social interactions — in particular, informal word-of-mouth communication among peers — affect an individual’s decision to participate in the stock market.

Setting. Starting in 2008, the Colombian Stock Exchange launched a series of professional courses on financial topics. Registered individuals were assigned to small sections that studied stock trading in a classroom setting (more than 13,000 students in 1,100 courses). We combine class records with administrative microdata of stock transactions to distinguish students with prior trading experience from those with no such background. We also use an electronic survey to elicit information about social interactions in the classroom.

Objective. We examine how social interactions and classmates’ past experience affect an individual’s decision to purchase stocks after finishing the training program.

Results. According to our survey, students engage in more investment conversations with peers during periods of high market volatility, when news about stocks is more salient. Importantly, we find that conversations about investments are more common in courses where peers have experienced positive returns in their most recent stock trades. We find that students who were assigned to groups with a high share of experienced classmates are more likely to start trading stocks after completing the course (figure 1), an effect that is stronger when peers have experienced large returns. Consistent with the idea that negative information is not transmitted, we find that negative returns do not affect market participation, and the relation between peer returns and entry comes solely from positive peer returns.

There is a negative side to social interactions. Among market entrants, those who share a classroom with peers that experienced large returns systematically underperform other rookie investors in their first year of trading.  In other words, individuals in groups where peers had positive past performance generate lower returns once they begin trading (figure 2). Overall, our results are consistent with the hypothesis that selective communication encourages more market entry among uninformed investors.  These investors overestimate the value of active trading and underperform once they enter the stock market.

Source: Escobar and Pedraza 2019.

Note: Figure 1 plots the average number of new market participants. Solid and dashed lines compare market participation across courses in the top and bottom quartiles sorted by Experience Rate (i.e., share of students with trading background in the course). Figure 2 plots the average returns of new investors calculated during their first 12 months of trading activity. The groups are sorted for quintiles of peer returns. The solid lines represent the upper and lower bounds of the confidence intervals at the 5% significance level.

Policy lessons. The financial education program we study aimed to provide information to improve financial decisions.  Contrary to this objective, selective communication among peers disseminated inaccurate signals and consequently promoted misguided ideas about personal investing. Overtrading in our setting arose because of mistaken beliefs. Thus, accurate information disclosure, especially about peer outcomes, should help improve financial choices. The evidence suggests that there can be benefits to targeting policy interventions to people with central positions in the social network, who are likely to receive and disseminate biased signals.

The final lesson might be a more personal one. When members of your social network share stories about their latest success, that information has probably been carefully selected. Forming an opinion under biased communication is likely to mislead people. Perhaps what your investor friends are not telling you is as valuable as what they are.

Reference

Escobar, L., and Alvaro Pedraza. 2019. Active Trading and (Poor) Performance: The Social Transmission Channel. Policy Research Working Paper 8767, World Bank, Washington, DC.