Word of mouth: An agent-based approach to predictability of stock prices

Abstract

This paper addresses how communication processes among investors affect stock prices formation, especially emerging predictability of stock prices, in financial markets. An agent based model, called the word of mouth model, is introduced for analyzing the problem. This model provides a simple, but sufficiently versatile, description of informational diffusion process and is successful in making lucidly explanation for the predictability of small sized stocks, which is a stylized fact in financial markets but difficult to resolve by traditional models. Our model also provides a rigorous examination of the under reaction hypothesis to informational shocks.