Highlights
- The study shows that less informed investors are more likely to share their private information, benefiting from the trading activity of more informed counterparts and influencing market dynamics.
- Highly informed investors tend to keep their information private, as sharing diminishes their informational advantage and reduces profits.
- This study demonstrates that information sharing enhances market efficiency but can worsen liquidity, with less informed investors gaining more profits and increasing trading volume under certain conditions.
Information sharing is ubiquitous in financial markets. In one study, a majority of institutional investors attributed their recent trades to discussions with peers. More recent studies have provided evidence suggesting that mutual fund managers place trades based on word-of-mouth communications found in the asset-management community.
In today’s environment, communication occurs across different channels, including the Internet, in social media outlets such as Twitter, Seeking Alpha, StockTwits, and Reddit, or in private Internet communities such as SumZero and Value Investors Club. It is not surprising that communications among investors are thought to have a profound influence on trading strategies and financial market outcomes.
Despite extensive empirical and anecdotal evidence, the theoretical basis for understanding information sharing in financial markets needs further development.
Of particular interest is whether those who share information are the ones who are most informed.
Sharing information is costly to investors, as it might reduce their informational advantage. Hence, it is essential to understand what benefit investors get from sharing information and under what circumstances they will choose to share information. Of particular interest is whether those who share information are the ones who are most informed.
From the point of view of informational efficiency, traders might not have the incentive to share information. Anecdotally, it seems that much of the information shared in financial markets comes from traders who are not particularly sophisticated. In this paper, the researchers developed a model that sheds new light on these issues.
They showed how information sharing can be beneficial for some traders because of how it affects the behaviour of other traders, and, most importantly, that the traders who choose to share information are the ones who are less informed. The researchers also explored the implications that this information sharing has for investor profits and market quality.
The study model is based on the Kyle framework, extended to allow investors to choose whether to share their private information before trading.
Existing theories do not ask the question of who shares information with whom and why, and the present researchers’ theory fills this void.
Existing theories do not ask the question of who shares information with whom and why, and the present researchers’ theory fills this void.
The theory predicts that an investor with coarse information optimally chooses to share information with a well-informed investor, because the former benefits from the latter trading against the shared information, which therefore dampens the former’s price impact. By contrast, the well-informed investor never shares information because doing so only dissipates the informational advantage and erodes profit accordingly.
Relative to the economy without information sharing, less informed investors make more profits as they are less concerned about their price impact, and they then trade more aggressively.
Paradoxically, the more informed investors earn fewer profits despite seeing more information because they trade less aggressively on their own information, and the market maker steepens the price schedule. Market efficiency improves, market liquidity worsens, and depending on the quality of the less informed investor’s information, total trading volume can be higher or lower.
Overall, the study model offers a novel and complementary explanation for why investors share information in financial markets. The equilibrium exhibits the unique feature that information transmits from the less informed investor to the more informed investor.
Keywords: Information sharing, Trading against error, Trading profits, Asset markets
* Learn more from the full research article here:
https://doi.org/10.1016/j.jfineco.2024.103967
