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

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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

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