The Stupidity of Social Investing Websites

Posted on September 5, 2008
Filed Under Web 2.0 Kool Aid |

I’ve always been somewhat amused by social investing websites like Cake Financial and Covestor. As someone who trades stocks and options for more than just fun, I have always believed the utility of services that look to help amateur investors by sharing the portfolios of their members and tracking results is minimal.

While a detailed discussion of my beliefs is beyond the scope of this blog and would be boringly technical, I found a good way to address the subject by using the announcement of Cake Financial’s new index fund - .

The Cakedex is “an index of the top 100 holdings of the top performers on Cake.” In the near future, the Cakedex a real index fund that investors can purchase.

Cake Financial touts that over the past five and half years, the Cakedex would have outperformed the S&P 500, the Dow Jones and the NASDAQ.

Fair enough - if you’re willing to ignore the fact that the bull market which ended this year started in 2003, making it possible for even monkeys to make money over the past five years (and many of them did).

But beyond this, there’s an important fundamental question - why would any amateur investor want to put money into a hodgepodge index fund whose holdings are based solely on the portfolios of a small number of unknown individuals who have supposedly done well by Cake Financial’s measure?

What knowledge and experience do they have? How have they performed in different kinds of markets? What rules and investment strategies do they adhere to?

Without answers to these questions, putting money in a Cakedex index fund is going to be a lot like giving money to a class of third graders and asking them to buy stocks with it.

To demonstrate this, I decided to look at some of the components of the Cakedex today.

Google (GOOG) makes up 2.63% of the Cakedex index this month. But it’s in a clear downtrend. The chart below is not one that an experienced trader trades long yet GOOG been in the Cakedex since May.

Washington Mutual (WM) has come off of its July lows but the chart is pretty clear - this is not a time to be long unless you’re trying to call a bottom (which you don’t do).

Why has Yahoo (YHOO) been in the Cakedex since May? With all of the Microsoft drama, YHOO wasn’t a stock for amateurs to “play” given the fact that it was a highly visible target for large institutions that like to “fool around.” And for those who traded YHOO in may, the chart made it clear by June that this wasn’t a stock worth holding long.

Potash (POT) is a stock I know extremely well from my own trading. It has been the beneficiary of commodities boom and the impressive uptrend seen on a one year daily chart shows this quite spectacularly. Although its underlying fundamentals are solid in my opinion, POT broke through the neckline of a head and shoulders formation recently, signaling a reversal. And as much as I like the company, a good company doesn’t always make a good investment and this turned into a short trade real quick, not a long one.

These are but a few examples I found of stocks in the Cakedex that break very simple and very basic trading rules. From oil companies to gold to financials, there is no shortage of Cakedex holdings that are fighting today’s market forces - and it took less than 15 minutes (and some very sloppy trendlines) to spot them.

Of course, it’s fair to point out that not everyone “believes” in technical analysis. But you can be sure that the traders at major institutions who are in business to take your money are paying attention to technicals and what I’ve done above isn’t anything more complicated than looking at a chart and drawing a line with a ruler. There are no special indicators other than price and price never lies.

It’s also fair to point out that people will say, “But Drama, buy and hold is a good strategy over the long-term. These stocks will come back at some point.”

Yes, everyone wants to believe that they’re a Warren Buffet even when it’s a bit more complicated than that.

In my opinion, buy and hold often equates to a hope and a prayer - especially in a market like this. I don’t advocate that the average investor trade day in and day out, but by looking at a one year daily price chart, drawing trendlines and recognizing common chart patterns, individuals can not only keep themselves out of bad new trades, they can exit existing ones before they turn bad.

Fewer bad new trades leads to lower losses and timely exits lead to maximized profits. What’s wrong with that? Nothing, unless you like sitting on losses and letting gains evaporate.

Unfortunately, I see no evidence that the best of the best on Cake Financial as reflected by the Cakedex index are anything more than amateur investors who don’t know what they’re really doing.

And the recent performance of the Cakedex seems to confirm that. The index lost nearly 10% in June, 8% in July, .15% in August and is down over 6% this month thus far.

For those keeping score, that’s almost 25% in less than 4 months. Painful.

At the end of the day, the Cakedex is an interesting novelty but not much more than that. If you’re looking for the wisdom of the crowd in the stock market, look at a price chart, not a social index fund.

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3 Responses to “The Stupidity of Social Investing Websites”

  1. Perry Blacher on September 6th, 2008 4:46 am

    Hi Drama 2.0. I am one of the founders of Covestor

    I have to say, albeit we were included in this critique we would totally agree with you. We don’t believe in the wisdom of the crowd, aggregate, sentiment etc as as you say the real question is why this crowd should be any smarter than the market.

    Covestor is instead all about great performing individual investors who today have much the same tools, access to information and transaction costs as the so called professionals. The site includes nothing of their collective ‘wisdom’ and never will. Covestor is more like an open source hedge fund, allowing any great individual investor (e.g. potentially yourself) - whether amateur/semi-professional or professional - to prove their credentials and benefit like a pro

  2. Drama 2.0 on September 7th, 2008 11:38 am

    Perry: thanks for dropping by. While I’m glad that you aren’t buying into this social investing “wisdom of the crowd nonsense,” some of the same critiques of Cake and the Cakedex still apply to Covestor.

    The concept of turning your members into open source hedge fund managers is certainly interesting but suffers from a number of problems.

    Looking at somebody’s track record on Covestor is certainly helpful - but only to a certain extent. It says nothing of their real experience and knowledge and doesn’t necessarily indicate that they have the ability to trade successfully in different types of markets. It also doesn’t guarantee that they will maintain the same investment profile over time.

    While hedge funds are lightly regulated, a legal entity exists, only accredited investors can participate, prospectuses are provided to prospective limited partners and contracts are signed.

    This does provide some protection and hedge fund managers have the same fidicuiary duties to their limited partners as other financial advisors (whether a breach of those duties is likely to result in any punishment is another matter completely of course).

    If I “mirror” a Covestor member’s trades, I don’t see how that member has any legal and fiduciary responsibilities to me. What if I “mirror” the trades of a Covestor member who previously only traded ETFs starts trading penny stocks, resulting in hefty losses?

    My feeling is that if you want to invest in a hedge fund, invest in a hedge fund. If you don’t have the capital to do so, that probably tells you something about the type of investment strategy you should be employing.

    Out of curiosity, I decided to look at your most successful members. I took your top member - timothysykes. Impressive performance this year but he boasts that he turned $12,415 into $1.65 million in 4 years trading penny stocks, which is certainly not something I’d want to promote. :)

    When looking at the stocks he’s trading, I see that he actively trades a hodgepodge of bizarre individual stocks that I personally wouldn’t touch with a ten foot pole.

    Take COINW - he’s traded these class A warrants for COIN (a stock he’s traded 36 times for a 1.61% loss) and made 9.21% over 26 trades.

    Putting aside the fact that this is probably far too many trades (even for a daytrader), there’s a bigger problem - COINW’s average volume appears to be around 26,000 shares per day.

    Why an experienced trader who ostensibly has over $1 million in the market would trade a low-priced, thin-volume stock is beyond me because such thin volume poses a lot of problems for the average investor (not the least of which is vulnerability to manipulation). Despite the percentage gain, there’s no real money to be had in his COINW trades.

    Just to put things in perspective - I and the person I trade for usually control at least $100,000 worth of stock with each trade - that’s $35,000 more than the total amount of COINW stock traded on an average day based on Friday’s closing price.

    The bottom line is that while it’s interesting (and potentially somewhat useful) to see what other people are trading in the fashion that your company allows users to, the practical benefit of this when it comes to making money is minimal as far as I’m concerned.

    Individuals should either take their chances with a “professional” entity that has some legal obligations and fiduciary duty to them or they should take control of their own trading and make their own decisions with minimal input from individuals who may or may not know what they’re doing.

  3. TechCrunch50 Finalists: First Impressions : The Drama 2.0 Show on September 8th, 2008 4:03 pm

    […] my comments on the Cakedex and Covestor. There’s a reason reputable brokers don’t let their […]

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Drama 2.0 spikes the Web 2.0 kool aid by providing critical analyses of Web 2.0, its people, its startups and its impact on the world of media. Other topics are explored when Drama 2.0 has been drinking too much 1975 Dom Perignon. Read more about the Internet's version of Keyser Söze here.