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Research Details

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

Abstract

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.

Type

Working Paper

Author(s)

Edward (Ned) Smith

Date Published

2018

Citations

Smith, Edward (Ned). 2018. The Effect of Investor Diversity on the Price Discovery Process in Financial Markets.

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