Markov Model of Word-of-Mouth Effect and Stock Market Participation

Abstract

The question of determinants of participation of stock market has long been a central question to financial economists. Most notably, Hong, Kubik,and Stein (2001) argue that social interactions affects the investment decision of potential stock market investors through two popular channels:

word-of-mouth and pleasure-in-talk about stock market. In this paper, I extend Hong et al.s model of social interactions to incorporate different effects of these two channels on stock market participation, conditioning on current market situation. The idea is intuitive: When potential investors observe current bull (bear) market, word-of-mouth and pleasure-in-talk effect

would work positively (negatively) toward stock market participation due to

increased number of peers who benefitted (lost their wealth) from bull (bear)

market situation. In Markov chain process framework, I model stock market

participation depending on current market situation and discuss empirical implications of my model.