When it comes to investment decisions, you can rely on your friends. Analyzing data from an online bank, economists around the Leibniz Institute for Financial Research SAFE detected positive peer effects in personal networks. The results show that individuals who followed their friends’ recommendations when deciding on their own investments seem to benefit from portfolios of higher quality.
It has already been studied that social connections may have an influence on the general participation in the market of risky assets. In SAFE Working Paper No. 353, the researchers now address the quality of investment tips. For this purpose, they studied Recommender-Follower pairs that had already been affiliated with each other personally prior to the recommendation. Via web link or Facebook, Recommenders suggested their online broker to people from their personal environment – Followers.
Personal connections help spread valuable information
"Friends can be good advisors when it comes to investment decisions," confirms Andreas Hackethal, Director of the Research Department "Household Finance" at SAFE and co-author of the paper. For this study, the researchers evaluated 515 Follower portfolios. Their portfolios were of higher quality than those of comparable individuals with the same demographic characteristics who had not been recommended the broker by their social network. "Those who responded and followed the recommendation of the online broker had, on average, a more diversified portfolio," Finance professor Hackethal continues.
The similar investment structures of Recommenders on the one hand and Followers on the other hand suggest peer effects. This effect suggests that people also share information about specific investments in their social environment. For example, Followers invested in asset classes like mutual funds and had better diversified portfolios. While the Followers' investments carried a higher proportion of risk, the better Sharpe ratio (the ratio of excess return to volatility of an investment) indicates that additional yield was earned compared to risk-free investments. "Investment decisions should not be made in mindless reliance on friends alone, but personal connections can help provide valuable information," Hackethal says. Social connections could equally propagate investment behavior that causes portfolio quality to be lower, but the study found this to be less common.
Due to the demographic composition of the sample, generalization of the results is limited: For instance, those observed as Recommenders are more likely to be wealthy and often have higher-quality portfolios. Furthermore, the study is limited to data from one German online bank.
