While low-cost investing with “robo-advice” is one solution gaining traction for helping people invest, an avant-garde option—one that actually makes people better investors—could be group investing via social networks.
It’s about empowering and educating individuals—improving financial literacy—through the combined wisdom and support of a group of people. That’s what investment clubs have been doing for decades.
These do-it-yourself mutual funds draw on the superiority of collective decision-making while following time-tested investment principles for building wealth over the long haul.
However, the investment club—typically 10 to 15 people meeting once a month to evaluate stocks and combine their purchasing power—is going the way of the dinosaur. It became a victim of the Internet, which has made researching stocks much easier.
But social networks via the Internet could be the catalyst for their resurrection. More and more, people are looking to their peers for answers, and given society’s low level of financial literacy—especially among younger generations—knowing how to invest in ever more complex financial markets, amid uncertain economic times, is a common challenge.
Thomas Beattie, CEO of Voleo, a Canadian financial technology startup that is creating an app for managing online investment clubs, envisions a change in social investing. “The old social was getting into a room,” he said. “The new social is meeting whenever and wherever you are to discuss something that’s come to a lot of your attentions.
“That’s our world.”
Wisdom of Crowds
It makes sense that our rationality is limited by the amount of information we can process. We have our biases, but also our areas of familiarity. More people generally means more wisdom.
The oft-cited example of the wisdom of crowds is an experiment by British psychologist Sir Francis Galton, who in 1906 asked 787 people at an agricultural fair to guess the weight of an ox. None of the people guessed correctly, but the average of all the guesses was one pound away from the true weight. It’s a case of individual biases cancelling each other out.
More recently, business columnist James Surowiecki studied the wisdom of crowds and concluded that, under the right conditions, groups are often smarter than the smartest people in them. The best decisions come through disagreements among group members.
“They say that the more complex the environment, the more you need diversity. This [stock market] seems like a pretty complex environment, so I would want to rely as much as possible on diversity of opinion,” said Brooke Harrington, associate professor of economic sociology at the Copenhagen Business School.
Harrington, who holds a doctorate in Sociology from Harvard, undertook the definitive study of investment clubs with the book “Pop Finance” in 2010. She coined the term “diversity premium” based on how men and women differ in the way they invest. She found that investment clubs with members of both sexes noticeably outperformed men-only or women-only clubs.
“The combination in a decision-making group can produce a synergistic diversity of views that is well-suited to the complexity of the stock market,” Harrington wrote in her book.
The independence of group members is key to getting that diversity of views and avoiding the herd mentality. “Crowds sometimes get that herd mentality,” Beattie said. “But at the smaller level of group, where you’ve got an interesting number of people, you can make some great decisions.”
It’s a small sample, but preliminary data from Voleo shows that groups outperformed individuals by 1 percent in a stock trading competition last summer.
The dynamics of the group are critical for its success. Harrington’s study showed that clubs formed primarily through professional bonds—as opposed to social ones—earned higher returns.
“One of the things that can torpedo group performance is when people are too socially enmeshed with one another. They can become reluctant to really be direct and honest with one another,” Harrington explained.
In addition, Harrington’s research showed that members of higher-earning clubs are more likely to openly debate each other’s ideas and let fewer investment proposals pass without dissent. High-performing clubs routinely allow members’ proposals to fail, such that only the best ideas are accepted.
For example, the collective decision-making of a club can help avoid panic selling, one of the biggest mistakes an individual investor can make. Suppose an investor sold the S&P 500 on Feb. 11. He or she would have locked in a 10.5 percent loss year-to-date while also missing out on the 13.3 percent rally from that date to April 1.
Group support and validation are fundamental needs for individuals. They can go a long way toward assuaging the fear of volatile markets and helping people make better investment decisions.
This support can be especially valuable for young people. “Young people struggle with barriers: money, knowledge, time, and fear,” Beattie said.
In an investment club, no one individual can make such a rash decision with pooled money. The investment club provides a form of social self-restraint since every decision needs to be vetted by the group.
“Knowing that your friends have all done what you did makes it a lot easier to go to sleep at night,” said Beattie.
Decline of an Institution
Beattie compares the secular decline of the investment club to that of board games.
“We all have a couple in our closets. We play them once a year maybe. But you look at the [online] gaming industry, it’s big, big business,” Beattie said.
The moral of Beattie’s analogy is that people consume games differently now. They play games on their smartphones with people around the world, while on the go. He believes people will start consuming financial information differently too.
And that applies to investment clubs.
“The sad part is since the dawn of Internet trading, which did mark, in my mind, the death knell for investment clubs, the evolution has been so minor,” Beattie said.
Web interfaces for discount brokerages all offer similar functionality and anybody can trade a stock with the click of a mouse.
Other factors behind the decline of investment clubs include discount brokerages with extensive education offerings, people leaving once they got the education they sought, and “market fatigue,” according to Adam Ritt, director of communications at the National Association of Investors Corporation, also known as BetterInvesting.
BetterInvesting is a non-profit organization that provides support to investment clubs in the U.S. It currently has 42,000 members, among whom 30,000 belong to 4,000 local clubs. This is a far cry from the approximately 500,000 members in the mid-1990s.
“Having two or three people do all the studies and make all the recommendations, and the other people are just along for the ride … that usually leads to disbandment sooner, rather than later,” Ritt noted.
“Also, you have a membership that is growing older, and so they retire. They disband their clubs,” Ritt said. “A lot of clubs break up because the treasurer leaves and nobody wants to pick up the mantle.”
Just as the booming equity markets during the mid-1990s made it cool to invest in stocks and saw investment clubs proliferate, the new millennium began by teaching stock market dabblers that what goes up can come down—hard.
Thus investment clubs got a double whammy from the Internet taking off in the late ’90s and the bursting of the dot com bubble.
“They were pretty badly shaken by the crisis that occurred between 2000 and 2004, which seemed catastrophic at the time,” said Harrington.
Back to the Future
If investment clubs are to prosper once again, they’ll have to mix the old with the new—the old being regular meetings, consistency of investment methodology, and group participation; the new being online and smartphone interactions.
Of course, face-to-face interaction is preferable, as greater breadth of information can be communicated more easily, but that format is less and less likely. Investment clubs had a successful run for decades based on face-to-face meetings.
“For someone who works crazy hours, a month-to-month-meeting investment club would probably almost never happen,” said Alyssa Randall.
Randall is a 27-year-old entrepreneur and MBA student in Toronto who belongs to an online investment club through the beta version of Voleo’s app. The rest of her group members are in Vancouver.
But, whether online or in person, the most important thing is that meetings achieve their objectives, Ritt says.
“I think the medium is less important than the relationships among the people and how those are handled,” Harrington said.
Randall, for her part, believes that being part of a club discussing stock trades and investing as a group is absolutely a good way for new investors to get started. She had no prior knowledge of investment clubs and relied on a third party to handle her investments.
Going forward, Ritt agrees that the investment club’s typical communication will increasingly take place online, but says it remains to be seen whether the traditional partnership of an investment club will continue.
“It might not be as much of a partnership as it is camaraderie of the investment club,” Ritt notes. People may just want to discuss stocks online without wanting to invest together.
The partnership—including the pooling of funds and paperwork to set up the club—may seem alien to newer generations of investors. However, it is part and parcel of reaping the benefits of group decision-making, cost sharing, and better returns than those that can be achieved by the typical individual.
Moreover, many people have sterile relationships with their financial advisers; it can be like seeing the doctor or car mechanic. Investment clubs, on the other hand, provide the environment to learn together by having skin in the game. There is more potential for hope in a group setting than in being on one’s own.
“I think investment clubs will always be useful for people to learn about investing, sort of as a self-help type arrangement,” Harrington said.
Randall seems convinced of their merit.
“I think that it’s something that I would use long term,” said Randall. “Not to manage my entire portfolio, but definitely a portion.”
And it’s critical to appreciate the long-term nature of the commitment in an investment club. This may seem antithetical to today’s world of smartphones and desire for instant gratification, but successful investing is not trading or speculation—it is achieved over the long run.
With technology, accessing the collective intelligence of groups makes a case for the investment club to stick around a bit longer. And those who participated in them have become better investors and improved their financial literacy.
Follow Rahul on Twitter @RV_ETBiz