Information Diffusion Effects in Individual Investors' Common Stock Purchases: Covet Thy Neighbors' Investment Choices

Using data on stock purchases individual investors made through a discount broker from 1991 to 1996, we study information diffusion effects the relation between household investment choices and those made by their neighbors. A ten percentage point increase in neighbors' purchases of stocks from an industry is associated with a two percentage point increase in the household's own purchases of stocks from that industry, with the effect considerably larger for purchases of local stocks. The presence of information diffusion effects is robust to controls for potential inside information effects and to household fixed effects. Upon controlling for aggregate trading patterns, households' and neighbors' investment style preferences, and the industry composition of local firms, we attribute approximately one-third to one-half of the overall diffusion effect to word-of-mouth communication. Disentangling the overall diffusion effect suggests that the significant relation between our measures of information diffusion and subsequent industry-level returns appears to be driven by its word-of-mouth component.