SMART INVESTOR: There's A Vital Flaw In The Framework Of Investment Clubs

Leah Busque, TaskRabbit CEO

Ever heard of an investment club?

Imagine a group of average investors who all get together (either in person or online), pool their assets, and make investments based on the collective mood of the club. 

Members study the market and they each participate based on the notion that a dozen heads knocked together must be better than one when it comes to stock picking.

But there’s a vital flaw in the framework –– it’s simply too narrow.

In a 2000 study by researchers Terrence Odean and Brad M. Barber, they found no less than 60% of investment clubs underperformed the market by 3% each year.

“[Investment clubs] typically lack diversity and have a tendency to be influenced by opinions of other members of the club,” writes Daniel R. Solin, senior vice president of Index Fund Advisors, in his book, “The Smartest Portfolio You’ll Ever Own.”

“Their collective judgment about stock prices is likely to be ‘unwise’ and certainly not as valuable as the views of the totality of the investment community outside their group.” 

Solin gave a Naples, Fla. investment club a rude awakening when they invited him out to witness their magic in motion. As a group, they decided the Vanguard Wellington Fund (VWELX) was essentially the bee’s knees of portfolios.

It was cheap and boasted a 5.58% annualized return between Sept. 2000 and Sept. 2010. For the decade period prior, it netted a 14.12% return.

How could they be wrong? 

Solin takes them down in two paragraphs: 

“I looked at the performance of all 60 balanced funds for which data were available … When funds outperformed in one period, they rarely were able to repeat that outperformance in the following period. The data demonstrated a statistically meaningless correlation between stellar performance in one period and similar performance in the next 10-year period.

If skill was a meaningful factor in outperformance, the correlation would be much higher. Think of it this way. In most areas of demonstrable expertise, you would see a persistency of the skill. It’s unlikely that Roger Federer will slip from his high ranking one year to competing in the qualifying rounds the next. The conclusion is inescapable that outperformance of these fund (or of any of them) was a random, unpredictable event, unrelated to the skill of the fund manager.”

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