Debunked Investment Clubs: Even Average Investor Groups Aren’t Very Good
Much has been written about the underperformance of individual investors: the small guy, on average, just doesn’t do very well against the market. In this study we look at investment clubs and show that when individual investors work together (think “Internet forums”) they don’t do much better… or maybe even worse.
Between 2001 and 08/2007, investment clubs in our study underperformed the market by a heartbreaking 4.5% a year; and that was before accounting for commissions, taxes and other trading costs.
What is an investment club? An investment club is a group of people who pool their money and invest together. The club buys or sells based on a majority vote or some other agreed method. In the US alone, clubs control tens of billions of dollars.
How we conduct our study
To conduct our study, we turned to one of the largest investment club accounting software providers, Acme Co. Of course, that’s not their real name, but we don’t want to run afoul of anyone’s legal team, so to the purpose of this study are Acme Co.
Acme maintains an index of the holdings of the thousands of clubs that use its software, representing several tens of millions of dollars in holdings. The index is hailed by Acme as an entirely scientific tool for determining how well investment clubs pick stocks. The index is weighted based on club holdings, rebalanced monthly and ignores trading costs such as commissions.
Now, Acme Co weren’t kind enough to provide a handy, fancy graph outlining how well the clubs performed against the market (that would be a bit counterproductive, wouldn’t it), but they were kind enough to provide a daily snapshot of the value of the investment club index since its inception. Our clever and not a little devious programmers simply wrote a software program to record this information on a daily basis.
And what do we find? Between 2001 and 08/2007, the index underperformed the S&P 500 by 4.5% per year (again, that’s without taking transaction costs into account). This abysmal performance was consistent throughout the entire sampled period.
Perhaps we are focusing too much on returns. Perhaps these investors are a risk-averse group that invests in lower-yielding investments to lower the risk level of their portfolio? That would be negative: the monthly standard deviation in the club’s portfolio was 5.2%, 35% higher than the S&P 500.
Going a step further, if we generously assume that trading costs hover around 2% per year, as is the case in the actively managed mutual fund industry, that brings the underperformance to around 6.5% per year… and well, that just makes me want to cry.
Transcendence
The only conclusion we can draw from these results is that investment clubs (and, by proxy, groups of individual investors) are simply not very good at managing a portfolio. Not just the meager 2% underperformance we see in “professionally managed” mutual funds, but a dizzying 6.5% underperformance.
I think investor engagement is being careful who pitches investment ideas – the good folks on that internet bulletin board may seem like a smart bunch, but the numbers show that on average they probably aren’t. So do your due diligence and expect empirical results, not just anecdotes.
happy Trading,
MarketSci.com