How does the rise of social media and financial influencers impact retail investors and financial markets? This study explores the phenomenon of social trading, whereby retail investors coordinate their trades through social media platforms including TikTok, as well as stock message boards such as WallStreetBets. The findings reveal that social trading harms retail investors to the benefit of professional investors such as hedge funds.

The global proliferation of social media has transformed financial markets, enabling retail investors to coordinate their trading activities in unprecedented ways. This phenomenon, known as social trading, involves retail investors sharing investment ideas and strategies on platforms such as Reddit, TikTok, and dedicated trading networks such as eToro. Financial influencers, or “finfluencers”, play a pivotal role and shape the investment decisions of millions, particularly among younger generations. This study investigates the impact of social trading on retail investors’ profits and market quality as measured through market liquidity and price efficiency. Market liquidity refers to the ease with which assets can be traded without significant effects on prices, while price efficiency measures how accurately market prices reflect the fundamental value of underlying assets.

Theoretical framework 

This study builds on Kyle’s seminal model of financial markets (1985), which examines the interaction between professional investors, retail investors, and market makers. Retail investors are modeled as noise traders, whose trades are uncorrelated to fundamental information about asset values. To capture the dynamics of social trading, the study introduces the novel element of the positive correlation between different retail investors’ market orders. This correlation reflects the coordinated behavior observed in social trading, whereby retail investors follow similar strategies based on shared information or advice. The model is analyzed in both static and dynamic settings. 

Retail investors lose, professional investors gain

The study’s key finding reveals that social trading increases expected losses for retail investors, while boosting profits for professional investors. The correlated behavior of retail investors that is induced by social trading amplifies their impact on market prices, creating new opportunities for professional investors to exploit.

Market liquidity and price efficiency tend to benefit

The impact of social trading on market quality is nuanced. In the static model involving a single trading date, social trading reduces market liquidity and has no impact on price efficiency. In the dynamic model involving two trading dates, the effects are more complex. If levels of social trading are weak, market liquidity improves on both trading dates. Additionally, price efficiency benefits from social trading on both trading dates. 

Empirical calibration of retail investors’ losses 

Using data on retail investor correlations from Haghighi et al. (2024), the study calibrates the losses borne by retail investors due to social trading. The computations suggest that social trading increases retail investors’ losses by 5.1 % compared to a scenario without social trading. In other words, for every dollar invested, retail investors lose more than an additional US$0.05 on average due to their coordinated behavior.

Policy implications

The rise of social trading has reshaped the retail investment landscape. While it undoubtedly increases retail investors’ participation in financial markets, the study highlights a dark side to this new phenomenon. By coordinating their trades, retail investors inadvertently create profit opportunities for professional investors, leading to greater financial losses on average.

However, from a general market perspective, there is a bright side to social trading. Social trading tends to increase both market liquidity and price efficiency. These benefits for the market as a whole come with collateral damage in the form of additional financial losses for retail investors. 

From a policy perspective, fears that social trading could jeopardize both price efficiency and financial stability can be dismissed based on the model results. However, in line with the warnings issued by relevant regulatory bodies such as the SEC and BaFin, this study serves as a cautionary tale for retail investors, urging them to critically evaluate the financial risks of social trading. While retail investors’ temptation to engage in social trading is high, the financial costs may be even greater.

References

Haghighi, A., R. Faff, and B. Oliver (2024), “Retail traders and co-movement: Evidence from Robinhood trading activity”, International Review of Financial Analysis 95, 103431. 

Kyle, A. S. (1985), “Continuous Auctions and Insider Trading”, Econometrica 53: 1315‑1335.