The Effect of Investor Diversity on the Price Discovery Process in Financial Markets

As orthodox and behavioral economists continue to wrangle over the question of whether markets are "efficient," a growing number of economic sociologists have begun to ask a different albeit related question: Under what conditions are financial markets more versus less efficient? (Zuckerman 2012; Zuckerman 2004; Bothner, Smith and White 2010; Smith and Chae 2016). Our aim here is to address this question directly by analyzing variance in the way new information about a firm is incorporated into its stock price. Combining insights from research on social networks (Lorraine and White 1971; Burt 1987), collective intelligence (Chen et al. 2014, Page 2008), and price setting in financial markets, we demonstrate that the efficiency of the price-setting process is directly affected by a firm’s location in what we refer to as the market’s “ownership network.” Specifically, we propose that when a firm’s investors hold similar stocks at similar times, those investors are more likely to share similar views, not just about a given stock in their portfolio but also about the broader market conditions to which the stock is exposed. Just as similar people behave in predictably similar ways in response to a given stimuli (cf. Pool, Stoffman, and Yonker 2015), we anticipate an analogous process among investment funds having overlapping portfolios. We hypothesize that the similarity versus dissimilarity of a firm’s investors will materially affect the speed, fidelity, and magnitude with which new information about a firm becomes reflected in its share price.