Better to hear all parties: Understanding the impact of homophily in online financial discussion

Abstract

• We investigate the impacts of homophily in online financial discussion on investor judgments, investment decisions, and market price efficiency. • Homophily reduces the accuracy of investor judgments on future stock returns and worsens investment decisions. • Homophily is associated with weaker immediate price reaction to earnings news and stronger post-earnings announcement drifts, implying reduced market price efficiency. As social media platforms have become popular venues for investors to share and exchange investment opinions to inform trading decisions, offline social phenomena such as homophily —defined as people’s inclination to seek interactions and associations with similar others—have also surfaced in online interactions. Yet relatively little is known about the economic consequences associated with investor homophily behavior in online social media. This study investigates how homophily in online financial discussion affects financial outcomes, particularly, investors’ judgments about assets’ future prospects and investment decisions, and overall market price efficiency. We theorize that, by reducing the diversity of information that investors access, homophily may lead to undesirable consequences for individual investors as well as the market as a whole. Analyzing approximately 33.5 million online postings by nearly 2.5 million investors from one of the largest social media platforms for investors in China, we find that, on average, homophily (1) reduces the accuracy of investor opinions about stocks’ future prospects, particularly, future stock returns, and (2) is associated with weaker immediate price reaction to earnings news and stronger post-earnings announcement drifts. Taken together, these findings reveal a dark side of homophily in online financial discussion, suggesting that falling prey to homophily could potentially lead to inferior investment decisions and welfare concerns, and aggregately, impair price efficiency and impede the efficient functioning of the capital market.