Crowdsourcing Your Investments: The Twitter Effect

NEW YORK (MainStreet)—When Twitter momentarily crashed the market with a false news event, an interesting question was raised: rather than destroy the market, can we profit off the minds of the collective herd? We can crowdsource a logo, the financing of a festival -- or our next indie film – how about crowdsourcing our investments? Traders are doing that right now on social investment platforms like eToro, ZuluTrade and ForexCopy. For now, due to regulatory restrictions, U.S. trading is limited to currency and commodity transactions.

As the largest player in the field, eToro.com lets you tap into the tribal "wisdom" of nearly 2.8 million users from 190 countries. You can choose your favorite market guru, share trades, copy those trades in your own portfolio – and according to ongoing MIT research – enhance your return by 5 to 10% over "normal" traders. Flush with a new $15 million round of venture capital, eToro allows you to get into the action for as little as $50.

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"I had been trading in the financial markets for a long time before establishing eToro, and I was always frustrated at the needless complexity of most the tools at my disposal," said Yoni Assia, founder of eToro. "I also realized that the Internet and the social movement that followed it would have to be an integral part of this new platform. Instead of investing in traditional market instruments, an eToro user can invest in another trader, and eventually build a 'people-based' portfolio."

Yaniv Altshuler, a post-doctoral associate at the MIT media lab headed by Professor Alex 'Sandy' Pentland, has been researching social investing for the past two years.

"A few years ago, the retail investor was at the bottom of the food chain," Altshuler said. "The fat cats -- the hedge fund managers -- were making the real money. So now, with access to the wisdom of the crowd, for the first time, retail investors can significantly improve their performance -- if the platform adheres to the correct model. So the hedge fund managers will have to settle for some lower returns."

"When you hear this concept of social trading you say, 'Why should people disclose their investment secrets to their peers? I want to make as much money as I can, why would I reveal my secrets?'" Altshuler says. "However my mathematical model stated that under some conditions this would actually help users make additional ROI."

So the concept of "help me help you" can actually enhance profit?

"Not all the time, but in many cases," Altshuler replied. "Our research can actually help guide the social network to make it as efficient as possible." Part of Altshuler's research has focused on ways to improve the flow of tribal information within social networks to make that knowledge more useful.

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Within the structure of a crowdsourced investment platform, certain "gurus" rise to the top with the most followers. So how do you know you are following a trading champion rather than a chump?

"This I cannot answer, because everyone has their own strategy for picking the gurus they want to follow," Altshuler admits. "I can tell you that if you show me the structure of the network that is formed, namely who is following whom, then I can tell you if this network is likely to generate a higher return or not. And if not, I can help you alter it via recommendations to improve the user return."

Altshuler says following several gurus rather than just one is a key component to successful investment crowdsourcing. "My research shows that, in general, social investing beats non-social investing, however -- it depends on the dynamic that evolves between the investors," he said.

Altshuler notes that if you follow the trades of like-minded investors, "echo chambers" form and the result is that you are basically following your own trading advice in an endless, unproductive loop. Just as having a mix of traditional investments lowers your risk, diversifying your trading gurus makes the internal structure more complex and enables what he calls the "sweet spot" of crowd wisdom. Altshuler calls that "tuning" the social network.

"I believe that we have only touched the tip of the iceberg, as far as the potential of social trading is concerned," eToro's Assia said. The company is constantly adding new features, such as its Social Index tool, which allows users to copy an entire index comprised of selected top traders.

Also see: Money Managing Machines: Should a Bot Invest for You?

Written by Hal M. Bundrick for MainStreet

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