Does the “wisdom of crowds” produce alpha?

CAPM / Alpha Theory 10 Feb 2008

The intersection of finance and technology is getting crowded.  Along with information aggregation services and social investing networks, today’s the O’Reilly MoneyTech conference in New York featured celebrity financial bloggers. Barry Ritholtz (The Big Picture), Roger Ehrenberg (Information Arbitrage), Veryan Allen (Hedge Fund Blog), and even the reclusive and media-shy Finbar Taggit (Fintag.com).   The event itself was moderated by blogger Paul Kedrosky (Infectious Greed) and counts among its four promotional partners, Footnoted.org and AllAboutAlpha.com.

One panel that raised a lot of interesting questions about the nature of alpha was a panel discussion on Collective Money Management.  For the uninitiated “collective money management” refers to networks of investors who pool their ideas together to come up with what is hoped to be the best trades.  Call it Facebook meets E*Trade I suppose.  Examples include Marketocracy, PredictWallStreet, Zecco, Cake Financial, Socialpicks.com, and Covestor.

These web sites were billed in the official programme as being the antithesis of the stock market – places where people freely share ideas in the hope that they will benefit by association with the network.  But while many emerging open source business models can seem counterintuitive, the idea that investors want to share their ideas isn’t realy counterintuitive or antithetical at all.  In fact, it’s in perfect keeping with the spirit of the market.  If an investor buys an undervalued stock, it’s actually in his best interests to tell others about his thesis since this will put upward pressure on the stock.

On the other hand, it would be against the investor’s self interest to share his stock pick before he actually executes the trade.  In other words, it would be against his interests to discuss his investment strategy.  But sharing stock picks isn’t really counterintuitive at all and shouldn’t be put in the same bucket as apparently selfless act of contributing to Wikipedia or Linux (which, as it turns out, might actually be enlightened self-interest).

But regardless of the particular model, collective money management begs the following question: Is out-performance alpha or it is luck? After all, if the social network (the collective) becomes large enough, it would become the market.  So it’s performance should eventually converge with that of the market.

Put another way: Does the wisdom of crowds produce alpha? To be sure, the wisdom of particular sub-group of people (who may have an informational advantage) would likely produce alpha.  But when the crowd becomes the market, any positive return become beta by definition, right?

Is the social network extracting alpha at the expense of everyone not part of the network (institutions, luddites, cavemen etc.)?  Marketocracy, a community of 100,000 stock pickers, has a mutual fund based on the picks of the top 100 investors each month.  Due to what appears to be a mild level of inter-month return persistence, the fund has actually beaten the S&P 500 since launch early this decade to late 2007.  Is this a tantalizing example of the wisdom of crowds?  Maybe, maybe not.  The fund seems to have since converged with the S&P500 in December, erasing much of its relative outperformance.  Still, it may snap back, so immediate conclusions should probably be avoided.

Another social network of investors is convened by PredictWallStreet.com (www.predictwallstreet.com).  These guys basically ask thousands of investors each day about whether the market will rise or fall the next day.  According to a white paper released today, the aggregate opinions of these thousands of investors are apparently a pretty good predictor of market performance the next day.

This begs its own questions.  If people are negative on the prospects of the market, shouldn’t that already be priced in?   If not, is this because the poll is done after markets close?  (ECNs and foreign markets should mitigate any such inefficiency.)  Or perhaps, as above, those polled represent a better-informed sub-sample of investors who are perpetually eating the lunches of the marginal market participant.  Or maybe this is just a statistical anomaly bound to correct itself given enough time.

Capital markets are the original social network.  Their outputs have themselves been described as “the wisdom of crowds”.  So the application of social networking (“Web 2.0″) to markets comes with a touch of irony.  One this is undeniable though, emerging Web 2.0 business models will likely provide new insights into some interesting questions regarding market efficiency, behavioral finance and alpha generation.

This is a new and interesting area of study and no one took this stuff in school.  We sure don’t have the answers here at AAA.  So we’d like to hear your thoughts and musings on some of these tools.  Just click the headline to make a comment.  Is this alpha, some kind of alternative beta, or a statistical anomaly?

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