Don't get beaten with an investment club

(MoneyWatch) I recently was asked if I thought investment clubs were a good way to learn about investing. As usual, the first thing I do is to cite the academic research, that way my advice is based on evidence and not my opinions. The research I cite evaluated the "trendy era" of investment clubs -- the 90s. The so called heyday of these clubs is far less appealing in hindsight.

Hazardous to your financial health

Professors Terrance Odean and Brad Barber examined the performance of investment clubs in their study, "Too Many Cooks Spoil the Profits: The Performance of Investment Clubs." The study covered 166 investment clubs, using data from a large brokerage house, from February 1991 to January 1997. They found that when performance was adjusted for exposure to the risk factors of size and value, alphas (performance above or below benchmark) were negative, even before transactions costs. After trading costs, the alphas were on average -4.4 percent per annum. They also found that the clubs would have been far better off if they never had traded during the year--beginning-of-the-year portfolios outperformed their actual holdings by 3.5 percent per annum. The reason was that the stocks they sold outperformed the stocks they bought by over 4 percent per annum. The conclusion is that investment clubs have something in common with individual investors--trading is hazardous to their financial health.

Examining the results of the Mensa (a high-IQ society) investment club provides an amusing example. If any group should be capable of showing that more heads are better than one and that intelligence translates into market-beating returns, it should be Mensa. The June 2001 issue of Smart Money reported that over the prior 15 years the Mensa investment club returned just 2.5 percent, underperforming the S&P 500 Index by almost 13 percent per annum. Warren Smith, an investor for thirty-five years, reported that his original investment of $5,300 had turned into $9,300. A similar investment in the S&P 500 Index would have produced almost $300,000. One investor described their strategy as buy low, sell lower.

Don't join the club

Even today, there's an overwhelming amount of evidence against investment clubs. These article titles alone --"Fun Fades at Investing Clubs," "Investment Clubs Lose Appeal," "Shedding a Tear Over Vanishing Investment Clubs"-- should be enough to ward of investors from joining. Past or present, the evidence is similar, and it's not very positive.

The problem with most clubs is that they focus on stock selection. And the academic evidence is overwhelming that trying to beat the market by identifying mispriced securities is a loser's game.

Thus, my conclusion is that while investment clubs can serve social functions like fostering friendships, individuals would be far better off joining a book club. Of course, every investment club probably believes it will be part of the minority that manages to outperform. To those optimistic groups, I offer Groucho Marx's words of wisdom: "I have a mind to join a club and beat you over the head with it."

Image courtesy of Flickr use James Cridland.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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