Investment Clubs Debunked - Even Groups of Average Investors Aren't Very Good

A lot has been written about individual investor underperformance - the little guy, on average, just doesn't fair very well against the market. In this study we set our sights on investment clubs and show that when individual investors work together (think "internet forums") they don't do much better...or perhaps even worse.

Between 2001 and 08/2007, investment clubs in our study underperformed the market by a gut wrenching 4.5% a year; and that was before accounting for commissions, taxes, and other costs of trading.

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

How We Performed Our Study

To perform our study we turned to one of the largest providers of investment club accounting software, Acme Co. That's not their real name of course, but we don't want to run afoul of anyone's crack legal team, so for the purpose of this study they're Acme Co.

Acme maintains an index of the holdings of the thousands of clubs using their software, representing several tens of millions of dollars in holdings. The index is hailed by Acme as a completely scientific tool for determining how well investment clubs pick stocks. The index is weighted based on club holdings, is rebalanced monthly, and ignores trading costs such as commissions.

Now, Acme Co was not so kind as to provide a handy-dandy-graph depicting how well clubs underperformed versus the market (that would be kind of self-defeating 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 ingenious and not a little devious programmers simply wrote a software program to record this information daily.

And what did we find? Between 2001 and 08/2007, the index underperformed the S&P 500 by 4.5% annually (again, that's before accounting for transaction costs). This abysmal performance was consistent across the entire period sampled.

Perhaps we're focusing too much on returns - maybe these investors are a risk-averse bunch investing in lower returning investments to decrease their level of portfolio risk? That would be a negatory - the monthly standard deviation on the club portfolio was 5.2%, 35% higher than the S&P 500.

Taking this one step further, if we generously assume that trading costs run somewhere around 2%/year as is in the actively-managed mutual fund industry, that brings the underperformance to somewhere around 6.5% a year…and well, that just makes me want to cry.

Implications

The only conclusion we can draw from these results is that investment clubs (and by proxy, groups of individual investors) just aren't very good at managing a portfolio. Not just the meager 2% underperformance we see from “professionally managed” mutual funds mind you, but a dizzying 6.5% kind of underperformance.

I think the implication for investors is to be careful 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 on average, they probably aren't. So do your due diligence and expect empirical results - not just anecdotes.

Happy Trading,
MarketSci.com