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"Man is by nature a social animal... He who lives without society is either a beast or God."
—Aristotle, "Politics," c. 328 B.C.
In 1935, Muzafer Sherif, one of the founders of social psychology, conducted a seminal experiment on the "social proof effect." He placed subjects in a dark room and asked them to look at a dot of light and estimate how much it was moving. In reality, the dot was not moving at all, but due to the autokinetic effect, how much it appears to move varies from individual to individual. Later on, each subject was paired with two other subjects and asked to provide their estimates out loud. Even though the subjects had previously given different estimates, the groups came to a common estimate. To rule out that the subjects were providing the group's estimate to avoid looking foolish, the experimenter had the subjects estimate the lights again by themselves, but they maintained the group's estimate. This social proof effect can be seen as the propensity of groups to conform whether they are correct or erroneous, and constitutes one example of the importance of social factors for judgment, behavior, and decision-making.
Standard neoclassical models in financial economics posit that investors and executives make decisions virtually in a vacuum and independently of social factors. In contrast, extensive evidence in social psychology and sociology suggests that fi nancial decisions are influenced by several potent social factors, which may be broadly categorized as: i) social interactions and networks ("peers"), ii) social capital, norms, and values ("culture"), and iii) social preferences and actions. Based on these building blocks, the field of Social Finance (e.g., Hirshleifer (2015)) has emerged and seeks to explain individual and corporate decision-making using social factors. Specifically, understanding social aspects of financial decisions will deepen our comprehension of a range of important financial phenomena, including trading activity, asset pricing dynamics, and corporate policies.
This Virtual Issue contains papers related to "Social and Cultural Issues in Finance" that have been published in the Journal of Financial and Quantitative Analysis in the past decade. The starting point was a search for words related to social factors, including social capital, culture, social norms, socialization, peers, social networks, social responsibility, social values. This produced a set of 15 fascinating papers which all increase our understanding of financial decision-making, whether by individual or institutional investors or by corporate executives.
A new and expanding literature in fi nancial economics examines the consequences of the flow of information through social networks for financial outcomes.
Inspired by well-known mathematician Daniel Bernoulli's model of the spread of smallpox, Shive (2010) introduces a new information-transmission model of trading behavior and creates a new social influence variable. Similar susceptible-infectious-recovered models are frequently used in epidemiology to model the dynamics of infection rates and the spread of diseases. Using a unique data set of virtually all daily trades in Finland during 1995-2003, she finds that the social influence variable, defined as the number of owners of a stock in a municipality multiplied by the number of investors who do not own the stock, is a significant predictor of individual investors' trading: A 10% increase in the social influence factor is associated with a 20% increase in the number of individual investor buys and sells, controlling for potentially confounding municipality-level characteristics. Importantly, her evidence suggests that social influence not only affects trading behavior but social influence-motivated trading also predicts stock returns, implying that individuals interact and share useful information about stocks.
If information propagates through social networks, does that impact public firms in any significant way? Cai, Walkling, and Yang (2016) examine one mechanism, namely the extent to which a selective transfer of private information through social networks increases the probability of informed trading. In particular, the authors use a detailed dataset from BoardEx of over 18,000 firm-year observations to identify social connections between a public firm's executives and directors and investment firms based on employment, education, as well as leisure activity ties. They find that the flow of potentially privileged information from corporate insiders to connected investment firms adversely affects a stock's liquidity: One additional connected executive or director is, on average, associated with a bid-ask spread for his or her firm's stock that is 1 basis point higher, and social ties overall account for approximately 15% of a firm's bid-ask spread. Interestingly, when a social connection is severed by an exogenous shock (death), trading costs by once-connected investment firms decrease. The paper is among the first to illustrate the potential costs of social ties to shareholders.
Having shown that social connections affect trading behavior and costs, it is also useful to ask if such ties affect the behavior of Chief Executive Officers (CEOs) themselves? Faleye, Kovacs, and Venkateswaran (2014) examine whether a CEO's social connectedness affects corporate innovation, in particular research and development (R&D). They use a sample of Standard & Poor (S&P) 1500 firms during 1997-2006, combined with BoardEx data, and find that CEOs who are socially more connected engage in more and higher quality innovation: An inter-quartile change in CEO connections is associated with an increase of about 10% in R&D, and also a significant increase in patent citations (as an innovation quality measure). This evidence of positive effects of CEO connectedness is particularly important given that other research has found that CEOs who are more socially connected often impose agency costs on their shareholders, e.g., through excessive pay packages and reduced pay-performance sensitivity. The authors report evidence in support of two mechanisms behind their findings. First, stronger social ties expands a CEO's access to investment-relevant information. Second, and perhaps more interestingly, a stronger social network for the CEO provides implicit labor market insurance, which reduces the downside inherent in risky corporate innovation activities.
It is important to emphasize that the importance of social connections may extend beyond executives and directors to, e.g., controlling family shareholders, which are very important in many (developing) economies around the world. Bunkanwanicha, Fan, and Wiwattanakantang (2013) study one specific social tie, namely marriage, among big business families in Thailand during 1991-2006. Using 131 wedding events, they document that a family's publicly traded stock experiences a positive return when a family member is marrying someone from another prominent business family, but not when marrying someone from an ordinary family (or a beauty contest winner or some other celebrity for that matter). In particular, such "network marriages" are associated with an 11-day cumulative abnormal return of 2.3%. The results are consistent with a network story: Marriage connects the son of one family with the daughter of another and marriage cements the social connections and creates firm ties on a secure and long-term basis (particularly because divorces are considered socially unacceptable in Thailand). The evidence of the importance of social family ties is consistent with a number of anecdotes, and reminiscent of the Rothschild family insignia with five arrows symbolizing the five sons who were dispatched to the five main European financial centers to conduct business.
Another important facet of social networks is "peer effects," i.e., the notion that agents in the economy imitate the actions of those in their peer group. While most of the published papers on peer effects in finance have concerned the stock market, Pan and Pirinsky (2015) examine peer effects in another important financial market, namely the housing market. Using detailed data from the U.S. Census, the authors examine about 4 million households, belonging to 126 different ethnic groups, across America. They uncover that the homeownership decisions of households are significantly related to the homeownership rates of households' ethnic group peers in the region: A one standard deviation increase in the homeownership rate of the reference group is associated with a six percentage point increase in the probability of owning a home, controlling for household-level as well as region-level characteristics. The authors also study the mechanisms behind such peer effects and find support for both information and status effects.
Social values, within a country, region, or company, have been found to explain financial outcomes. As a result, the papers reviewed in this section are broadly related to the influence of culture, i.e., norms and values shared within a subset of social peers. As Zingales (2015) concludes, "The 'cultural revolution' in finance has just started, and it opens an infinite set of possibilities."
Burns, Minnick, and Starks (2017) argue that the level and structure of CEO compensation may be influenced by cultural values since they manifest themselves in social systems, including corporate governance structures. Employing a large sample of firms in 14 countries, they show that the CEO tournament structure (measured alternatively as the ratio or the difference of pay between the CEO and other top executives within a firm) vary systematically with a country's cultural characteristics. Importantly, they find that steeper tournament structures are more effective at improving firm value in countries that value power distance and competition. They also report that firm value increases under steeper CEO tournaments when a country's citizens believe income differentials based on effort are fair outcomes. This evidence is consistent with the U.S. being a "winner-takes-all" culture while, e.g., Germany has legal requirements that CEO pay be "reasonable," reflecting different cultural attitudes.
A country's culture may not only influence corporate governance structures but also a firm's performance. Nahata, Hazarika, and Tandon (2014) study a sample of almost 10,000 global venture capital (VC) investments across 30 developed and emerging economies. They use standard Hofstede country culture data, and perhaps surprisingly, uncover that cultural distance between the countries of the portfolio company and its lead investor positively affects VC performance. Further analysis reveals that VCs, expecting cultural differences, have stronger incentives to invest in more intense ex ante screening. In addition, they find that local VC participation enhances success and reduces foreign VCs' "liability of foreignness" in developed economies.
Social capital has been found to impact not only equity but also debt contracting. Hasan, Hoi, Wu, and Zhang (2017) find that firms headquartered in U.S. counties with higher levels of social capital, e.g., measured by existence of social organizations or organ donations, enjoy lower bank loan spreads. They also find that high-social-capital firms face loosened non-price loan terms and lower at-issue bond spreads. The authors conclude that corporate borrowers feel the peer pressure from the local community to act in accordance with the prevalent social norms. Fearing social consequences, such as exclusion and loss of reputation, executives bow to the pressure of the social group and engage less in self-serving and opportunistic behavior. Thus, lenders perceive moral hazard as less of a significant problem and lower their compensation requirements accordingly.
Religion is another specific aspect of social values and culture, and several papers have studied the relation between religion and financial outcomes. Callen and Fang (2015) argue that religion affects executives in several different ways. First, religious managers are less likely to manipulate the flow of corporate information. Second, managers in religious regions pay a higher price in terms of social stigma if they are caught manipulating information. Finally, a religious milieu fosters potential whistleblowers who feel religion-bound to unmask manipulators. Consistent with such arguments, they find that firms headquartered in relatively more religious regions exhibit lower levels of future stock price crash risk. This evidence is consistent with religion, curbing so-called "bad-news-hoarding" activities, i.e., the systematic withholding of bad news from shareholders.
Social norms may also constrain the behavior of institutional portfolio managers. Specifically, Kumar and Page (2014) conjecture that institutional investors deviate from their norms only when the potential benefits are large. As a concrete example, the manager of a public pension fund may avoid "sin stocks" simply because of the negative public image of investing in companies that promote vice. Nonetheless, suppose a portfolio manager receives an information signal that the stock of R.J. Reynolds (a tobacco company) is significantly underpriced. Because social norms impose an additional cost of holding R.J. Reynolds stock, the portfolio manager would require a relatively stronger signal, all else equal, to engage in a trade. They find that institutional investors averse to holding sin stocks actually earn superior abnormal returns when they invest in such stocks, suggesting that portfolio managers' deviations from social norms signal informed trading.
Several papers also show that CEOs' preferences, and thus potentially firm behavior, are influenced by culture. Pan, Siegel, and Wang (2017) examine a company's "risk culture," i.e., the risk preferences among a firm's top managers. They find persistent commonality in risk preferences within firms, which arises through the selection of top managers with similar preferences and is rooted in the firm's original risk culture, i.e., the founders' risk preferences. Changes in risk culture over time impact corporate investment policies, whereas cross-sectional differences in founders' risk preferences contribute to differences in R&D. Hutton, Jiang, and Kumar (2014) conjecture that the personal political preferences of executives influence corporate policies. They find that Republican managers who are likely to have conservative ideologies adopt and maintain more conservative corporate policies, including lower levels of corporate debt, lower R&D, and less risky investment projects. The paper is among the first to show evidence of "behavioral consistency," i.e., the notion that CEOs behave in a similar way in the personal and professional domains.
The papers reviewed in this section are broadly related to i) corporate social responsibility (CSR) and ii) socially responsible investing (SRI), important facets of social actions that have recently received attention by financial economists. These have been controversial topics ever since Friedman (1970) stated: "[t]he social responsibility of a business is to increase its profits."
Corporate social responsibility may influence shareholder value. Importantly, Fernando, Sharfman, and Uysal (2017) find a stark asymmetry between socially responsible corporate actions that reduce a firm's exposure to environmental risk (e.g., litigation) and those that enhance its perceived environmental friendliness ("greenness"). Institutional investors shun stocks with high environmental risk exposure, which therefore have lower valuations. In contrast, firms that increase greenness do not create shareholder value and are also avoided by institutional investors. That is, investment in greenness beyond the mitigation of environmental risk exposure does not increase firm value, but may in fact destroy firm value.
Preferences for socially responsible investing may impact investor behavior. Bollen (2007) is one of the first papers to study SRI and compares the flow-to-performance sensitivity of socially responsible versus other mutual funds. He finds that the monthly volatility of flows is lower for socially responsible funds. Socially responsible investors exhibit a significantly larger response to positive returns than investors in other funds. Interestingly, and consistent with a notion of loyalty, socially responsible investors exhibit a smaller response to negative returns than investors in other funds. These results indicate that investors derive utility from owning the securities of companies that are consistent with a set of personal values or societal concerns.
Other papers study the asset pricing implications of screens adopted by socially responsible investors. Pre-existing explanations for abnormal positive returns for "sin stocks" include litigation risk, illiquidity, and neglect, i.e., characteristics that raise average returns. Luo and Balvers (2017) relate the sin stock premium to systematic risk arising from the nonpecuniary preferences of investors engaged in SRI, i.e., self-restricted investors in effect boycotting sin stocks. They find that an investor boycott risk factor is useful in explaining mean returns across industries, and its premium varies over time in a predictable way depending on the intensity of the boycott (SRI sentiment) and with the business cycle.
It is time to extend the study of investors and executives to include social factors such as i) social interactions and networks, ii) social capital, norms, and values, and iii) social preferences and actions. This review of a decade of papers on financial decision-making and social factors reveals that authors publishing in the Journal of Financial and Quantitative Analysis have already contributed significantly to the emerging field of Social Finance by augmenting standard neoclassical models in financial economics with important insights from social psychology and sociology. While some progress has been made, this field is still in its infancy, suggesting a straightforward prediction: Many more fascinating papers on social and cultural issues in finance will be forthcoming in the Journal of Financial and Quantitative Analysis in a not too distant future.
[1]University of Miami Business School, Department of Finance (hcronqvist@mbs.miami.edu).
[2]Désirée-Jessica Pély provided excellent research assistance.
Friedman, M., 1970. The social responsibility of business is to increase its profits. New York Times.