If Crowdfunding is the New Day Trading, Look Out

In an essay earlier this week on the evolution of money and finance, GigaOM founder and venture capitalist Om Malik argued that crowdfunding will be the new day trading, the latest financial innovation to “cut costs and [drive] wider participation in a previously closed and clubby market.” Advocates of crowdfunding had better hope not.

Paul Volcker famously said the only financial innovation to improve society in recent memory was the ATM. Not everyone agrees. In an essay earlier this week on the evolution of money and finance, GigaOM founder and venture capitalist Om Malik argued that crowdfunding will be the new day trading, the latest financial innovation to “cut costs and [drive] wider participation in a previously closed and clubby market.” Advocates of crowdfunding had better hope not.

To be clear, Malik isn’t talking about Kickstarter where funders make a donation that acts like a pre-order. He’s talking about the public buying stock in private companies, something that may soon be legal thanks to the JOBS Act, and which took a step forward this week with new rules from the SEC allowing private companies to advertise investment opportunities for accredited (read: rich) investors. Now startups and hedge funds alike can advertise the fact that they’re raising money, and some day soon you or I might join wealthier citizens in investing in them.

There’s no doubt that this will drive broader participation in startup investing, but the comparison to day trading confirms crowdfunding skeptics’ greatest fear: that when the party’s over, the public will be left with substantially lighter wallets.

That’s what happened in the case of day trading.

A 2004 study of day traders in Taiwan concluded that, while a small group of traders made money consistently, “more than eight out of ten day traders lose money.” (Subsequent research determined that fewer than 1% of day traders consistently beat the market.) Two of the same researchers found something similar in a broader paper in 2000 on stock trading by U.S. households (not just day trading), which they provocatively titled “Trading is Hazardous to Your Wealth.” Once commission was taken into account, the researchers determined that households did substantially worse than they would have done investing in index funds. Notably, they found that the more households traded, the worse they did:

Our most dramatic empirical evidence is provided by the 20 percent of households that trade most often. With average monthly turnover of in excess of 20 percent, these households turn their common stock portfolios over more than twice annually. The gross returns earned by these high-turnover households are unremarkable, and their net returns are anemic. The net returns lag a value-weighted market index by 46 basis points per month (or 5.5 percent annually). After a reasonable accounting for the fact that the average high-turnover household tilts its common stock investments toward small value stocks with high market risk, the underperformance averages 86 basis points per month (or 10.3 percent annually).

In other words, it’s far from clear that widening participation in the stock market — at least at the level of active trading by individuals — was a good thing.

Malik nods toward this problem, writing of financial innovations:

People race to try it, hoping to earn higher returns, and that works; for a while, anyway. Inevitably, however, the innovation attracts too many newcomers that those returns collapse, leaving huge losses

In the case of day trading, at least, the data suggests lack of knowledge is a more relevant constraint than timing; nonetheless the questions at hand are whether such “innovation” does us much good, and whether equity crowdfunding will be any different.

There are reasons for skepticism: venture capital as an asset class has underperformed the S&P 500 for the last decade, and pouring more capital into VC has historically led to lower returns. Only the top 20% or so of VC firms have a track record of beating the market, and they have the advantage of seeing the best deals (which may never be available to the average crowdfunding investor, at least at comparable terms).

In the case of startups, at least, the time frames involved are long enough that frequent trading is basically impossible. But the central bias the researchers identified as causing individual stock traders to lose money is just as relevant for crowdfunding: “People are overconfident.”

When it comes to the stock market, the deck is firmly stacked against the little guy, and so the best way for most people to invest in it is through a boring old index fund. If investing in startups is anything like picking stocks in that sense, there’s likely to be a dark side to democratization.

Source: HBR blog – Walter Frick
Link: http://blogs.hbr.org/2013/09/if-crowdfunding-is-the-new-day-trading-look-out/

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