Your network matters, but not always to your benefit

Financial markets are a social phenomenon. It’s the aggregate opinions and actions of millions of institutions and individuals. Hence, there is a common belief that who you know matters for your performance. If you are well connected, you may get valuable insights into stocks or markets that may provide you with an information edge. So, the most connected investors should do better than less connected investors? Right? Well, not so fast.

Late last year I stumbled over a study that I found extremely fascinating. This study looked at the holdings of all institutional investors in the US with more than $100m in portfolio assets and their holdings in US stocks. Based on these holdings, they assumed that institutions that have a larger overlap in their portfolio holdings may be more closely connected to each other either because they talk to each other more frequently or they have a similar investment approach and thus think about stocks in a similar way (and presumably reach similar conclusions).

These overlaps in portfolio holdings between institutions allowed the researchers to examine the network of connections between them and split institutions into more connected and less connected (more peripheral) institutions. Before you protest, I readily admit that this measure of connectedness is suboptimal at best but think about it this way. The financial press is full of articles and books about the investment approach of Warren Buffett, the latest decisions in major pension funds like CalPers, or the filings of major hedge funds. While I may not talk to Warren Buffett or anyone at CalPers regularly, if my investment approach is similar to theirs, I will definitely pay attention to these articles and their investment decisions are likely to influence mine.

In the worst case, I might even decide to change my beliefs about a company, or an investment based on the actions of these prominent, ‘more connected’ institutions. I might have information about a company that contradicts the views of these more connected institutions, but I might still go along with the ‘mainstream’ view simply because they must surely know what I know about the company as well.

The result is that the more connected institutions generate a herding effect where more investors follow in their footsteps and as this herd of investors moves in and out of a specific stock, the price starts to drift.

What the study found was that more connected institutions do indeed create such a herding effect and that this herding effect tends to move share prices away from fair value, particularly in the case of smaller companies with less liquidity.

Meanwhile, the less connected, more peripheral institutions that are not as influential tend to act more based on their analysis and less on what their peers are doing. If they move in and out of a stock, nobody cares and as a result, their moves tend to push overvalued stocks down and undervalued stocks up towards fair value.

The result is not necessarily that more connected or more peripheral institutions have better returns, but that they make money on different time horizons. The more connected institutions tend to create a short-term trend in share prices, so they get a boost to their returns for the next three to six months. But once the herd effect subsides, the return expectation for investments made by more connected institutions are lower and they start to underperform over time horizons of one year or more.

More peripheral institutions, on the other hand, tend to underperform in the short-term but have higher returns over investment horizons of one year or more simply because they don’t participate in these short-term hypes and rather invest based on fundamentals and their private analysis.

The lesson for us is thus that we need to pay attention to these more connected and more prominent institutions if we are traders or have a shorter time horizon of several months. For the rest of us who are long-term investors, it is beneficial not to read this news about prominent investors and their trades at all because it will just influence our decision-making process without giving us any edge in the market.