Investor Clubs vs. Individual Investors: Is There a 'Better' Way to Invest?

Dec.28.08 | About: SPDR S&P (SPY)
One last quantitative post before the New Year…

A lot of studies have been done looking at individual investor underperformance. It’s been pretty well established that the little guy, on average, doesn’t fare very well against the market. In this study I’ll look at investment clubs and show that when individual investors work together (think “internet forums”) they don’t do much better…and maybe even worse.

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[logarithmically-scaled]

What is an investment club? It is a group of individuals who pool their money to invest together. The club buys or sells based on a majority vote or some other agreed upon method. In the U.S. alone, clubs drive tens of billions of dollars.

The graph above shows the S&P 500 index (blue) versus an “average” investment club (red) from 2001.

To represent investment clubs, I pulled together data from Bivio, one of the larger club-accounting software providers. It maintains an index that it calls a “completely scientific tool to determine how well investment clubs pick stocks.” In a nutshell, the Bivio index is a 50 stock index of the holdings of all of the clubs actively using its software, weighted by dollars invested, and updated monthly.

Now, Bivio doesn’t provide a historical graph of returns (I’m guessing because it would help to make clear just how bad most clubs are), but with a little legwork, I made the data submit to my will.

For the number lovers:

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Across every metric, investment clubs fared poorly. To make matters worse, these results are “frictionless” – they don’t account for transaction costs or slippage.

Reason for Underperformance:

I would bet a dollar to a dime that the underperformance has nothing to do with the specific stocks held. Any stock-picking ability would be most likely drowned out by such a large basket of stocks (just ask the mutual fund industry about that).

The problem lies in the clubs’ poor market-timing ability. To illustrate, the next graph shows S&P 500 returns (blue) and the beta of the club index (EOY) each year.

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What is beta? In the simplest terms, it is a measure of how much of the portfolio’s return is driven by the broader market. A value of 0 = not at all, 1 = market risk, greater than 1 = greater than market risk.

Note how beta was high during the years 2001 and 2002 (when it should have been low) and fell to below 1 during the best year 2003 (when it should have been high). This mistiming continued over the entire 8 years – the clubs bore less market risk when times were good and more when times were bad - the exact opposite of what they should have done.

Implications:

The only conclusion you can draw from these results is that investment clubs (and by proxy, groups of individual investors) just aren’t very good at managing their money. It’s not just the meager 2% underperformance we’ve come to expect from “professionally managed” mutual funds.

I think the implication for investors is to be careful about who you toss around investment ideas with - the fine folks on that internet bulletin board may seem like a savvy bunch, but the numbers show that this probably isn’t the case. So, do your own due-diligence, embrace the empirical and ignore the anecdotal, and trade smarter.

[P.S. Just to be clear, these results should not, in any way reflect poorly on Bivio. I’ve used its software myself and think it has an excellent product.]