Can the Wisdom of Crowds Help you Predict Stock Prices?

by robekulick

This National Bureau of Economic Research (“NBER”) working paper, one of the most prestigious economic research organizations, indicates that the answer maybe yes…to some extent.

Avery et. al explain:

“We study the predictive power of approximately 2.5 million stock picks submitted by individual users to the “CAPS” website run by the Motley Fool company (www.caps.fool.com). These picks prove to be surprisingly informative about future stock prices. Indeed, a strategy of shorting stocks with a disproportionate number of negative picks on the site and buying stocks with a disproportionate number of positive picks produces a return of over nine percent per annum over the sample period. These results are mostly driven by the fact that negative picks on the site strongly predict future stock price declines; positive picks on the site produce returns that are statistically indistinguishable from the market. A Fama French decomposition suggests that these results are largely due to stock-picking rather than style factors or market timing.”

A link to the NBER version the paper can be found here:

http://www.nber.org/papers/w17298

An earlier, free version of the paper can be found here:

http://www.hks.harvard.edu/fs/rzeckhau/CAPS.pdf

CAPS is a system run by Motley Fool that lets people vote on what they think the future holds for individual stocks. Based on these votes CAPS assigns a 1 to 5 star rating to the stock in question. Here is a link:

http://caps.fool.com/

What this paper seems to indicate is that the CAPS system does a good job determining whether a stock is likely to underperform the market. So can this information be used to your advantage?

Well first note, that the authors find  “positive picks on the site produce returns that are statistically indistinguishable from the market.”  This confirms what I’ve argued many times on this blog that it is very difficult to beat the market buying stocks.

Second, to the extent that the authors have been able to generate above market returns using the information from CAPS it is largely from the shorting of the lowest rated stocks on CAPS. So can you use this information to your advantage? I’m not really sure. Short-selling is a very tricky business and is subject to very high transaction costs. These transaction costs maybe high enough that it simply isn’t cost effective for the individual investor to try this strategy. Also, short-selling introduces all sorts of timing issues that I would highly recommend the average investor steer clear of.

Finally, what this paper does suggest is that if you’re thinking of buying a stock, check its rating in the CAPS database. If it has a very low rating you may want to consider, based on this research, not buying the stock. Of course, I would advise not buying and selling individual stocks in the first place…stick with index funds. But for those of you for whom that strategy is just too boring, this research may at least help you avoid some costly mistakes.

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