The double-edged sword of investing and social networks: consensus trading

Back when investing was more of a closed ol’ boys network, there wasn’t a ton of original research going on. When one person got a good idea — or rather, they got good information from a company or analyst — it spread around via brokers to their client circles.

What emerged was a consensus trade — large groups of people all investing in the same thing at the same time. Consensus can work in two ways:

  1. very successful: when the trade works, it makes everyone a lot of money
  2. bottom drops out and everyone suffers: but when it doesn’t, well, it compounds the losses of all involved.

Hedge funds not doing their own original research

In a recent paper, Dangerous Connections: Hedge Funds, Brokers, and the Emergence of a Consensus Trade (here’s a version of an older paper), researchers at the London School of Economics found that there were very distinct social networks in place among top hedge fund mangers including analysts, traders, and brokers who service them.

By studying how information spreads, researchers highlighted a crowded trade (VW/Porsche in 2008) that sucked in numerous hedge funds, many of whom lost big money when the trade went against them.

Social networks: amplifying effect

One of the researchers, Yuval Milo described that these interconnections between funds and brokers serves as an “amplifying mechanism”:

“They increase the likelihood that a group of hedge funds can all head off in a wrong direction with an investment idea. We found that this is not just a fringe phenomenon. There is enough of it going on to make the market vulnerable.”

 Social networks for the rest of us

Hedge funds rely on these social networks to learn of new opportunities and to share their own. By talking up their book, analysts can get feedback on their ideas and spread them, increasing the chance that other big money steps in on the same side of the trade.

As individual investors, we’re sharing our ideas, too. Whether we share individual trades on Seeking Alpha or StockTwits or maybe we’re sharing our investing/trading strategies on Covestor or Collective2 or perhaps we’re giving our best shot at creating smarter financial forecasts on Estimize or developing investment ideas on Motif Investing, regardless, we have a great opportunity to learn from our networks.

De-echoing the investing social network

This is an amazing opportunity to hone our investing skills and discover great teachers along the way. But it can also be an echo chamber — amplifying like-minded ideas to those people pre-inclined to gravitate towards these investing ideas.

To capture the true value in the collective Tradestream, investors need to ensure they remain balanced and don’t turn out dissenting voices or ideas too much.  In a world where we can fine-tune our news to completely conform with our prior beliefs, our investing can suffer if we don’t populate our tradestreams with contrarian views.

How do you ensure that you’re not preaching to the choir? let me know in the comments

Sh*t investors say

I know, I know…It may be trite but I thought it would be a fun post to write.

Sh*t investors say

  1. “I want to turn $100k into $5 million”: Possible? Yes. Likely? No. It’s a real discussion going on on Quora now. The best way to grow a portfolio is by continuing to add to it (even better if your employer can match — that’s free money). To get 75% compounded returns, I personally like the answer to buy a $7 million life insurance policy and have an “accident”.
  2. “But Suze Orman says to…”: I hear this one a lot. It’s best not to have gurus. Not Suze. Not Dave. Not me. These guys are great to learn from. Go ahead and glean. The good ones are great teachers and offer great learning opportunities. But they’re out to build their own businesses. And as we’re learning in SuzeOrmanGate (my term), they’re liable to sell you stuff that’s just not good for you. I’m not picking on Orman — she’s done great things for people. But gurus are human and stumble sometimes.
  3. This investing stuff is easy”: No, it’s not. Sure, clicking buy or sell on your online trading account is pretty simple but the act of investing — planning, risk management, asset allocation — is hard. At least just for the fact that much of the process requires us to fight against our natural, human inclinations.
  4. “This strategy is a printing press — it always works”: Strategies work until they don’t. Many strategies, like my hedge fund piggybacking strategy, was developed by backtesting results. I don’t expect it to EVER work as well as the results because I designed it to maximum those results.
  5. “Well, Buffett owns it”: Hey, I’m a big fan of following the smart money. Heck, hedge fund replication strategies are built upon the idea that they know more than we do. But don’t ever confuse a single stock pick for an investment strategy. When Buffett buys something, it’s a piece of a larger pie, an additional piece in an investing puzzle known only to him. Beware of cherrypicking guru stock picks.
  6. “You should check out this hot little small cap I just bought. I’m up 100% already”: OK, tough guy. I’d like to see your cost basis on this one. Not that I accuse you of lying but people stretch the truth when talking about their winning ideas. They also don’t happen to mention the ones that they got wrong. Unless they’re audited results like Chris Camillo posted (he turned $20k into $2M — I guess they could be forged), take these claims with a very large bucket of salt.
  7. “You should really subscribe to this penny stock newsletter I get. Great info”: Investors — many smart, educated people — turn their brains off when they subscribe to free or premium newsletters. Many blindly swing at every pitch. The penny stock newsletters are published by stock manipulators. They get paid by large investors to prop up prices, so they can exit their positions. Many are compensated in stock, which incentivizes them to pump ’em up.
  8. “I’m out! This market is rigged.”: Well, it might be but it still plays by some rules. Insiders have always profited — leveling the playing field with REG FD (requiring public disclosures of important information) didn’t change that. But use the tilt in the field to your advantage. Mimic the insiders and create strategies that follow their trading. I just wrote a free ebook: The Harvard Guide to Insider Trading that describes this technique.
  9. “I don’t know what to do — my broker sucks a$$”: He might. Many do, but there are plenty of trustworthy good financial professionals (yes, even brokers) out there. They put their clients first not matter whether they have taken the fiduciary duty or not. But if you’ve had bad luck, keep looking. Try an online advisor like Covestor (I do freelancing work ) or Personal Capital. or Wealthfront (I’m a freelance writer).  Use Wikinvest portfolio tools (I’m an editorial contributor) or portfolio optimizer, Jemstep. I especially like what Hedgeable is doing. Don’t be complacent – there are new solutions out there that may just work better than the old ones.
  10. “My friends and I are getting into a small real estate deal. We’ll let you in if you behave.”: Sounds like an investment cult to me. If they’re really your friends, I’m not sure you’d have to beg to get into a small deal they’re putting together. Friends get burnt all the time by getting sucked into sucker deals. That doesn’t mean to take a pass on everything that comes your way but it does mean to be very, very, very, very, very picky about who and what you invest in.

photo by indi.ca

[Free Webinar]: From the ground up: Building a better money management business

This event was already held. Check out this event’s presentation, Building an investment advisory business from the ground up.

From the ground up: How to build a successful money management firm

Join us for a Webinar on May 16
Space is limited.
Reserve your Webinar seat now at:
https://www3.gotomeeting.com/register/545041518
Is your investment practice what you want it to be? 

Many professional investors have changed their business models over the past few years.  Wirehouse brokers are breaking out and going independent. Many are choosing to start or join existing RIAs.  Many others are creating their own hedge funds.

Everyone is looking for the right business model, the right structure for their investment business.

Cale Smith, founder of Islamorada Investment Management, believes he’s built a better investment business mousetrap.

Called Spoke Funds®, these structures solve some of the problems associated with mutual funds (underperformance, tax inefficiency) and hedge funds (compensation schemes masquerading as an asset class).

The Spoke Fund® structure aligns incentives by ensuring the investment manager invests most of his liquid net worth in the same portfolio he’s selling to investors.

In this webinar, you’ll learn:

  • why the existing vehicles for your business (mutual/hedge funds) are broken
  • How Spoke Funds solve these problems
  • Why Spoke Funds are perfect for managers who are value investors
  • How they lower start-up costs and get into business faster
  • How their transparency is attracting a new class of investor

Please join Zack Miller of Tradestreaming.com and Cale Smith of Islamorada Investment Management for a frank and open chat about the future of the investment management business.

Title: From the ground up: How to build a successful money management firm
Date: Monday, May 16, 2011
Time: 4:00 PM – 5:00 PM EDT
After registering you will receive a confirmation email containing information about joining the Webinar.
System Requirements
PC-based attendees
Required: Windows® 7, Vista, XP or 2003 Server
Macintosh®-based attendees
Required: Mac OS® X 10.4.11 (Tiger®) or newer

 

The Future of Investing, Startups, and the $11,000,000,000,000 Question

Online finance lags

The news of personal finance tool Wesabe shutting down last year made it pretty clear that Mint.com is on its way to fully owning the online personal finance space.  The company’s port-mortem pretty much capitulates that.  But personal finance is just a small part of a much larger, overarching problem that affects all of us: planning for a financial future.  While this certainly includes managing household cash flows, it also involves buying a home, choosing 401(k) plans, putting money into the stock market and fixed income investments, and planning for retirement.

This begs the question: with so much money at stake, why does online finance continue to trail other industries like travel? When planning an international trip online, I know exactly whom to trust for advice and why they’re trustworthy, where to look to compare similar products, and have transactional platforms into which to submit my order.  But in finance, most people still don’t even know where to begin.

Hedge fund traders are using supercomputing high-frequency trading tools to make money in good markets and bad while we still can’t even decide which mutual funds are right for us. We require truly comprehensive solutions instead the current piecemeal, silo-based approach in online finance.  At stake is our future and over $11 trillion of mutual fund assets in the U.S.

Current Players

You can look at the way competition is shaping up online in various silos:
  • Personal Finance: Startups in this space are focused on developing value-added services to help users track and manage money flows.
    • Tracking/Tweaking: Mint.com has done really well capturing new users to adopt web/mobile tools, just as Quicken was a similarly powerful force on the PC.  Intuit, which now owns both products, is positioned really well for future expansion.   Personal finance is a huge problem to tackle and it’s really early in the game.
  • Investing: The investing process involves researching various options, transacting, and ongoing portfolio management with analytic tools.
    • Researching: Investors begin the investment process with idea discovery, bubbling up ideas to populate their portfolios.
      • Piggybacking investment ideas: New services like AlphaClone not only make easier tracking of the investment activities of storied investors like Warren Buffett but also provide portfolio development tools to backtest and manage entire portfolios made up of piggybacked ideas.
      • Long tail of financial content: As the costs of publishing have been pushed to zero, we’re enjoying a bull market in investment content.  Sites like Seeking Alpha and StockTwits provide great tools to plug into the collective tradestream. Wikinvest has taken more of a collaborative approach with its content and data.
      • Screening 2.0: Smarter tools like Validea help investors filter through large numbers of stocks using algorithms and artificial intelligence to identify worthy portfolio prospects.
      • Crowdsourcing stock picks: Sites like Piqqem allow investors to tap the wisdom of the investment crowds.
      • Expert networks: SumZero is an online investing club of super-smart people sharing really good analysis on stocks.  Other Q&A tools like those at LinkedIn and Quora and even Facebook are enabling the sourcing of ideas from domain experts.  With the FBI/SEC’s crackdown on offline expert networks, investors will look more towards these tools for help in sourcing and validating investment ideas.
    • Transacting: Once an investor knows what action he would like to take, execution comes next.
      • Online Brokers: E*Trade, TDAmeritrade, and Schwab still dominate the online brokerage space (with recent news that Merrill Lynch is getting back into the game).  It’s interesting to watch as online brokers woo existing traditional brokerage clients with automated, professional-grade services delivered online, blurring the line between full-service and DIY investing.
      • Hybrids: Covestor and kaChing (now Wealthfront) are the eBays of investment advisory services — marketplaces of investment services.  Users synch their online brokerage accounts to mirror the portfolio models managed by advisors on these platforms.  In a move to the mainstream, Covestor’s tradestream now includes the real time audited trades from participating investment managers.  This is a big fuckin’ deal and it’s freely available through Yahoo Finance’s Market Pulse.  Newer entrants like Tech Crunch Disrupt finalist Betterment provide automated investment services.  Other investment advisors like Formula Investing provide a mixture of full service and DIY tools.
    • Managing:
      • Ongoing monitoring:  As markets undulate and investors’ financial health changes, tools help automate changes that should be made in portfolios.  A number of new professional-grade, automated tools are helping head this cause.  Firms like MarketRiders help with ongoing changes in asset allocation and services like Goalgami help address life’s incessant barrage of financial goals that need planning.
      • New asset managers: Fusing the low-cost distribution model that social media affords with new methodologies to manage funds for clients, both old and new asset managers are launching all kinds of new securities in an attempt to capture part of a huge pie.  With actively managed ETFs in the infancy and good comps for successful exits, new asset managers like GlobalX are growing AUM and positioning themselves well for future growth.
      • Analytics:  Like Google’s Urchin/Analytics acquisition, analytics are core to the effective management of any platform.  TC Tear Down star, Steve Carpenter founded and sold Cake Financial to E*Trade earlier in 2010.  Cake helped investors make more sense of the activities in their portfolios. With Cake Financial bowing out, the market is wide open.  Look to Wikinvest’s recently launched Portfolio tool to take off where Cake left off.

Why there is still a huge window of opportunity

In spite of the flurry of activity, most of these startups haven’t even begun to dent the market for financial services.  Some of these verticals are so narrow that participants need to expand horizontally  into other silos, which both incumbents and startups are racing to do.

Some firms have advanced product-based approaches, trying to build better mutual fund mousetraps and have enjoyed a modicum of success. Next-generation mutual funds, exchange traded funds (ETFs) have almost $800 billion in assets, an increase of 34% over 2009 levels, but that’s still only 7% of all invested assets in the U.S.  In spite of all the high quality content, investors still struggle with basic financial concepts, portfolio management, and continue to make bad decisions.  The flurry of activity has unleashed a bull market in financial content; We’ve gone from scarcity to too much content.  We now require tools to cut through the data smog and help us with comprehensive solutions to make better decisions.

The $11,000,000,000,000 Grand Prize goes to…

The market size of the investment industry is so big that there is room for multiple players to establish hugely profitable businesses.  Look for large incumbent players, most specifically Bloomberg, to expand their businesses through acquisition in an attempt to capture more marketshare.  Bloomberg’s multi-billion dollar empire of financial hardware and data recently purchased BusinessWeek in an attempt to move downstream toward retail investors.  The giant investment expert network, Gerson Lehrman Group, may get deeper into online expert Q&A sourcing as the firm continues to enable person-to-person expert research for professional investors.

Real-time transparency is making  its way to the online brokers.  E*Trade joined TDAmeritrade in recently announcing upgrades to its own API to allow 3rd party software developers and services to reach investors through their brokerage logins – the holy grail for the entire value chain.  Investors get access to new apps, software developers can finally tap online brokerage clients through trading platforms, and the online brokers can provide value-added services without having to develop them.

The fact that we’re beginning to seeing ivory-tower asset managers make their way onto Twitter is, in fact, a good sign of things to come in the future.  But the field is still wide open for comprehensive solutions.

photo courtesy of frankblacknoir