How social networks influence investors

This article appears in the February 2021 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.

Clients may arrive in your office (or on your screen) with their heads full of investment ideas. A recent paper on “social finance” from the National Bureau of Economic Research explains why.

“Classic models of economic behaviour have not traditionally featured a role for social interactions between individuals,” authors Theresa Kuchler and Johannes Stroebel wrote. “But, as Aristotle famously noted, humans are, by nature, social animals. As a result, interactions with other individuals are likely to influence most decisions we make through a variety of channels beyond market prices.”

The authors reviewed social finance research and described the forces competing to influence clients’ financial decisions.

The influence isn’t always positive. Peers provide useful information but also “distort investment and borrowing decisions due to social comparisons, belief contagion, and investment or consumption due to a fear of missing out,” the paper said.

One of the papers surveyed found that investors who live near each other are more likely to purchase the same stocks. Another found that people were more likely to invest in stocks when their peers had recently seen higher returns.

While those findings covered retail investors, professionals also aren’t immune to social pressures. Fund managers who reside in the same neighbourhood tend to overlap in their investment choices, one paper found. “These correlations are also larger when managers share a similar ethnic background and are therefore more likely to interact with each other due to well-documented homophily in social networks,” the authors wrote.

They also highlighted research that used Facebook data to show how institutional investors are more likely to invest in firms based in regions where they have social ties. This goes beyond the traditional “home bias” effect that results from geographic proximity, the paper said, to include digital ties.

Social groups also affect spending. Data from Canada show that borrowing and bankruptcies increase among a lottery winner’s neighbours as they spend conspicuously to keep up with their peer’s sudden wealth. A similar study showed that neighbours of lottery winners in the Netherlands spend more on cars.

How to compete with these irrational forces? One method may be to simply explain their existence. Clients may find it easier to avoid potentially damaging behaviour when it’s described neutrally as something other people do — even professional investors.

The challenge for advisors is that friends, colleagues and family are often seen as a source of unbiased information and advice, the authors wrote, whereas advisors may “have real or perceived conflicts of interest with the individuals they are supposed to advise.” Being frank about potential conflicts could mitigate this effect.

“Social Finance,” by Theresa Kuchler and Johannes Stroebel (both from New York University’s Stern School of Business), was published in the NBER Working Paper Series in October 2020