Here Comes The Crowd: How Investing Is Changing

Includes: DIA, QQQ, SPY
by: Alexander Wallin

The ground is shifting beneath the surface of the financial services industry. New technology, new behaviors, and new methods of organization are all affecting how people manage their financial lives, most notably among the younger generation. These individuals are growing up surrounded by innovative digital platforms that share one thing in common: they are driven by crowdsourcing.

Though not a new concept, crowdsourcing has yet to be fully applied in the investment world. For those unfamiliar, crowdsourcing is based on the assumption that humans are often emotional, rather than logical, decision makers. When it comes to making investing decisions, research shows that retail investors often lead with their hearts (or guts, whichever you prefer) and not their brains. Fortunately we live in an age when technology may be utilized to overcome these emotional impulses by tapping into a resource more reliable than our own instincts: the wisdom of the crowd.

Collectively, we are more intelligent and capable of making better decisions than the smartest individual among us, as long as the given group is large and diverse enough. The web is particularly useful in facilitating this type of interaction, including interaction between investors. I researched this issue during my time at UCSD, and found that with the right application of crowdsourcing, an investor could create a portfolio capable of outperforming the S&P 500 18 out of 20 quarters and pick outperforming stocks with an 87% certainty. These results line up with other similar studies.

Along the same lines, a study by Bollen et al. (2011) used Twitter sentiment to predict stock market fluctuations with an accuracy of, believe it or not, 87%. Another by Chen et al. (2011) found that activity on a popular finance blog could predict stock returns and earnings surprises: the more activity an article had, the stronger its effect. Yet another study by Yi (2009) found that mentions of a stock in social media could boost its trading price.

But more than just helping individuals improve their investing knowledge, crowdsourcing is expanding existing funding models - creating new opportunities for investors as well as businesses. As the SEC deadline approaches, crowdfunding (i.e. the crowdsourcing of funds) and the Jumpstart Our Business Startups (JOBS) Act are in the spotlight. However, the multiple crowdfunding models are often confused and misunderstood. Each model has its own idiosyncrasies that are important in order to gain a clear understanding of the future of investing.

The first model, and most familiar, is donation-based crowdfunding. Think Kickstarter. In the donation/pledging category there are a multitude of incentives for the individual who pledges capital to a company. The most common are gifts, prizes, rewards, and product pre-orders. This is great for B2C companies or artists, especially for those with low fixed expenses, fairly low marginal costs, and easily manufactured products.

It is no coincidence that the top three segments with highest success rates on Kickstarter are Dance (75%), Theater (71%), and Music (68%). They have low fixed expenses without any prohibitive upfront costs to get started. Once an album or show's production costs have been covered, the marginal cost is very low and the process does not require hundreds of individuals.

However, there are examples of successful projects in which the individual backer had no personal interaction or engagement with the end product, other than the bragging rights. A good example is the Washington Monument, the completion of which was actually crowdfunded after construction was halted between 1854 and 1877.

The next model is investment-based crowdfunding. This model of crowdfunding is quite different from the well-known donation-based model discussed above, and thus it is important to distinguish between the two.

Investment-based crowdfunding can be divided into two sub-types: debt and equity.

First, debt-based crowdfunding is already a plausible way to fund a startup in the United States. For instance, Lending Club generates about $50 million in new loans each month and is growing at a rate of approximately 100% a year. The benefits of this model are twofold. It allows entrepreneurs to raise capital without giving away part of their company and the cost basis for the crowdfunding is known, as the entrepreneur sets the interest rate and the amount of money to be raised. However, debt-based crowdfunding does not inspire the same involvement as equity-based crowdfunding since the interest rate is fixed, thus the investors won't see any additional upside if the company becomes wildly successful (and they could lose their entire investment if the company goes bust), nor will it draw the potential pre-sale demand/audience commonly created by donation-based crowdfunding.

Second, and perhaps the most exciting, model is equity-based crowdfunding, although it is not currently possible in the U.S., except for tight-knit networks of accredited investors. Equity-based crowdfunding is the most complex of all the crowdfunding models, but also has the potential to become the most powerful. A few important details: the JOBS Act imposes limits to how much an individual can invest through an equity-based crowdfunding round each year. For example, someone who makes between $40k - $90k annually may only invest 5% of his or her annual income. The company raising capital also must obtain audited financial statements if it intends to raise more than $500k. Lastly, the regulation of equity-based crowdfunding platforms is much more complex than that of other models and these transactions must be channeled through a registered broker/dealer.

Equity-based crowdfunding provides a real chance for entrepreneurs with great ambitions and creative ideas to secure funding at an earlier stage than would be possible following the traditional venture capital route. But it also provides a new type of investment opportunity for retail investors. Now Main Street folks have a chance to get in on the ground floor of a startup before angels and VC firms move in. The investment is much riskier but the payoff can be incredible.

In order to wrap one's head around the potential created by crowdfunding, consider this hypothetical. Pretend for a moment that the JOBS act existed in 2004 and that Facebook (NASDAQ:FB) initiated an equity-based crowdfunding round of $500k instead of seeking Peter Thiel's seed investment. If you had invested $100, how would your investment have performed? Well, if you had sold your investment at $40/share during the IPO, your $100 would have been worth $1.4 million. Most would agree that this is not a bad return.

The crowd is coming. So what does it all mean for you? The JOBS Act is currently in the hands of the SEC, but by Jan. 1, 2013, individual investors will have the unique opportunity to seek out companies they are particularly confident in and invest early. Burgeoning entrepreneurs will have easier access to capital, which will in turn spur technological innovation and create new jobs. And the intermediary role currently held by banks in the funding cycle will shrink, as companies will have additional means of sourcing capital.

My recommendation? On New Year's Day, if you can afford it, budget $1000 for the year to invest in a handful of your favorite startups and small businesses. There are a lot of talented people and great ideas out there. The JOBS Act promises to give those great ideas the opportunity to develop into full-fledged, profitable companies. And if you're still on the fence, just remember the Facebook hypothetical: turning $100 into $1.4 million is nothing to scoff at. No one enjoys losing money; however, most would agree sacrificing the cost of a nice pair of jeans is worth the possibility of a high-return investment.

As a small business owner, I am excited to be a part of this technological and financial revolution, and I think you should be, too.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.