Author: Elizabeth Bolton
Topic: Social Media Investing
Information Asymmetry addresses the discrepancy of information available to different parties in a decision-making process. In relation to the stock market, information asymmetry refers to some investors having more access to information that is relevant in valuing than other investors – a condition that this results in market inefficiency.
The introduction of social media in the early 2010s has made information more readily available to broader audiences. While social media may help reduce information asymmetry, its tendency to promote herd mentality amongst uninformed investors may have adverse consequences on market efficiency.
Herd Mentality
Herd mentality is the human impulse to follow the actions of others as a form of “fitting in” – in other words, it’s an extension of every college student’s “fear of missing out” (FOMO). The implications of this thought-process is nothing new – especially in terms of the stock market. In fact, herd mentality has played a significant role in many previous financial crises including the 17th-century tulip fever, and the internet bubble of the early 2000s.
Social media enhances this “so-called” herd mentality effect because of each platform’s algorithms designed to keep users on the app. At the most basic level, this means that users will receive a feed of videos based on previous videos that they have viewed, and/or liked; this can create a type of “echo-chamber.” An echo chamber – an environment that reinforces an individual’s confirmation bias and limits exposure to diverse perspectives. In short, users are only exposed to content that they want to view, rather than content that reflects objective truths. This influx of biased information can exacerbate perceived market risks, potentially leading to widespread panic and uninformed investment decisions.
Effect on Market Efficiency
The online presence of herd mentality can have negative impacts on the market’s efficiency. Market efficiency is the ability of market prices to accurately reflect all relevant information. There are three recognized forms of market efficiency: weak, semi-strong, and strong. In weak form markets, the use of past pricing information is not helpful in predicting future pricing trends. Semi-strong market prices reflect all public current, and past information – note that private information is not included in these markets. If all markets were strong-form, this would mean that all information – past, present, public, and private – would be reflected in the market prices, and therefore, there would be no way to gain an unfair advantage in the markets (Investopedia). Although there is much debate over the current form of market efficiency, many claim that the semi-strong form is the most common.
However, as social media increasingly fosters environments in which investors are subject to increasing amounts of misinformation and extreme views, market efficiency is at risk of worsening. Moreover, how social media affects market efficiency may disproportionately affect retail investors. Retail investors are individuals that invest for personal gain, and future financial gains, but do not have any professional backing.
In contrast, institutional investors, and accredited investors are individuals with a high net-worth, and/or licensed financial professionals that have extensive experience dealing with investments and the financial world in general. Given this information gap between institutional and retail investors, retail investors are more likely to be affected by the negative impact of social media on market efficiency, because of their lack of experience in market settings and tendency to be influenced by fake news online from non-accredited sources.
Conclusion
All in all, in an effort to connect individuals with similar interests – spawning thousands of online micro-communities – social media holds the unintended power of having adverse impacts on financial markets in terms of market efficiency. Market inefficiencies – such as those like information asymmetry – can affect uninformed, inexperienced retail investors, leading to poor financial decisions and diminished trust in the market.
References
Qadan, Mahmoud, and Gideon Saar. “Social Media, Herding, and Stock Market Efficiency.” Journal of Financial Markets, vol. 67, 2023, https://www-sciencedirect-com.ezproxy.library.wisc.edu/science/article/pii/S1059056023001326?via%3Dihub.