We've all heard the adage that when even the cab driver is giving you stock tips, it might be a good time to sell. But a new academic study suggests that when an online financial community provides advice, it might be better to avoid buying in the first place, too.
A soon to be published paper, Does Online Community Participation Foster Risky Financial Behavior? (Zhu, Rui, Dholakia, Utpal M., Chen, Xinlei and Algesheimer, René; Sept. 12, 2011), has some pretty broad sweeping implications for investors. The authors suggest that being an active participant on online bulletin boards, forums and other communities increases risk-seeking tendencies in financial decisions.
One of the online communities studied was Prosper.com which brings together individuals looking for loans with investors looking to lend money. After following 600 lenders over 18 months, the ones who participated more actively in the community by posting more messages on the forums or making more bids for loans, among other criteria for participation, possessed riskier loan portfolios than less active participants.
The other online community studied was eBay, specifically the German portal, eBay.de. This was a longitudinal study over two years which started with over 13,000 users who were not using the community's forums. It later divided them into two groups: one which continued to not use the forums, and the other group whose members were invited to join the forum communities.
Risky behaviour for eBay users has previously been linked to the number of bids they make per auction, which in turn can be indicative of bidding frenzies and can lead to higher winning bid amounts. Overpaying for an item leads to increased buyer's remorse as well as greater financial risk since the likelihood of making a profit is decreased if the buyer were to resell the item.
This second study confirmed the results of the first. Increased community participation correlated significantly with increased risk-seeking behaviour.
I called up one of the paper's authors, Dr. Utpal Dholakia, professor of management at Rice University, and before I could even get my first question in, he addressed the main concern I wrote about earlier this year when trying to differentiate between correlation and causality in non-academic marketing The paper's authors also controlled for self-selection bias (in this case, the tendency that someone who would be inclined to participate in an online forum exhibits the traits associated with riskier financial decision-making regardless of the degree of participation).
So the results have real world implications on many fronts. While it's possible that participating in an online brokerage's forums for individual stocks can increase the risk in an overall investment portfolio, the tendency to increase risk-seeking behaviour could extend to other communities such as illness support groups. "The participation in such a group could lead to patients choosing riskier treatment options which could prove more harmful than helpful in the end," said Dr. Dholakia.
And here is potentially the worst part. Obviously, taking on more risk is not a bad thing if the decision pans out for you. But in the case of the Prosper.com loan portfolios, the return on investment actually correlated inversely with the increased risk of active participants.
It's not only financial advice from strangers on the street that should raise your guard, be wary of online friends too.