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Are individual investors insane? Individual investors may have something to teach institutional investors yet they are making a mistake and often ignoring their own wisdom. In a recent article, I noted the increasing dominance of machines and algorithmic trading in financial markets. Algorithmic trading is based on using patterns in data to extrapolate information about companies and future stock prices.
Yet some situations are difficult to describe with data. Humans are better than machines at understanding and digesting complex situations. That is where individual investors have an advantage. But individuals are often wrong – instead the value of individual opinions is in understanding how those opinions reflect sentiment and consensus views of firms. It turns out that most human investors do a bad job of synthesizing that information and computers are doing a good job on that front. The key tool for computers in this type of sentiment and opinion synthesis is called textual analysis.
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Textual analysis requires feeding a dictionary of words to a computer and teaching the computer positive and negative words and phrases so it can read articles on behalf of the investor. The computer then can make trading decisions based on trading rules built around the opinions of hundreds or thousands of investors communicating through news sites, social media, comment streams, and message boards. It’s a tricky business and it has to be done correctly, but studies by financial economists have consistently shown that the methodology is a good way to general alpha.
For instance, several recent studies have shown that social media and news outlets like OilPrice.com, Twitter, and Seeking Alpha are useful for predicting future returns of stocks based on market sentiment. Computers can be programmed to assess this sentiment in a way. Most individual investors ignore this information. That result is consistent with past studies that have shown individual investors have poor long term investing skills.
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Individual investors probably aren’t happy about the lack of performance, but as Einstein once said, the definition of insanity is doing the same thing over and over and expecting different results. Instead of relying on subjective judgements of their own, individuals could do much better by taking a page out of the book of textual analysis investors. There are lots of distinct ways that individuals can gain a leg up on the broader market – political intelligence is one surprisingly cheap option for instance that both individual and institutional investors should consider.
Most individual investors are probably not well prepared to create a computer program that will do textual analysis. But investors can still do some basic simple analysis on their own. Going through news sites and social media sites to get a feel for the broad expectations and sentiment around a stock does not require a computer program.
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Yet many investors make two common mistakes when dealing with their investments. First, many investors completely ignore the value of online financial news and analysis. They don’t spend as much time on their portfolios as they should. Second, and more importantly for those reading this article (who by definition probably don’t make the first mistake), readers of financial media are often dogmatic in their views. People tend to treat stock investing like politics and become rigid adherents to a given view. Computers and algorithmic trading programs don’t do this. If the signals indicate that energy stocks are a bad investment, then they sell. If the signals indicate they are a good investment, they buy. Investors could benefit by being more flexible and remembering that their personal view about a stock is unimportant – what matters is the sentiment of the crowd, and flexible traders will do better than those who are dogmatic in their views.
By Michael McDonald of Oilprice.com
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Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…