Monday, July 26, 2010

Are you an investor that uses message boards? Read this.

Are you an investor that uses stock message boards? This is for you and the results are not friendly to sites like seekingalpha. Turns out the uncertain and noisy environment provided by (most) message boards actually works against investors.

JaeHong Park, Prabhudev Konana, Bin Gu, Alok Kumar and Rajagopal Raghunathan conclude that investors use stock message boards to seek information that meets (rather than disproves) their prior beliefs. Prior studies accounting and finance suggest that virtual communities often provide more accurate information than analyst forecasts. For example, early evidences of Enron collapse from accounting tricks were first reported in message boards.

Abstract: Using data from a new field experiment in South Korea, we study how information from virtual communities such as stock message boards influences investors’ trading decisions and investment performance. Motivated by recent studies in psychology, we conjecture that investors would use message boards to seek information that confirms their prior beliefs. This confirmation bias would make them more overconfident and adversely affect their investment performance. An analysis of 502 investor responses from the largest message board operator in South Korea supports our conjecture. We find that investors exhibit confirmation bias when they process information from message boards. We also demonstrate that investors with stronger confirmation bias exhibit greater overconfidence. Those investors have higher expectations about their performance, trade more frequently, but obtain lower realized returns. Collectively, these results suggest that participation in virtual communities increases investors’ propensity to commit investment mistakes and is likely to be detrimental to their investment performance.

some excerpts...
On the value of boards:
The value of these message boards in information processing and decision-making can be explained using both economic and psychological perspectives. However, these two perspectives suggest different behaviors. From an economic perspective, one would expect that message boards have a beneficial effect, since they provide timely information at a much lower search cost (Birchler and Butler 2007). The economic principle suggests that individuals are rational in obtaining information (Birchler and Butler 2007). That is, they tend to seek information without any bias, objectively assess the relevance and veracity of each piece of information, and integrate the information in forming an investment strategy that may yield better investment performance. On the contrary, psychological studies indicate that virtual communities may not necessarily make investors more informed or lead to better investment performance. In particular, the behavioral finance literature shows that psychological biases, particularly in an uncertain and noisy environment, influence investors’ information processing behavior (Kahneman and Riepe 1998, Barber and Odean 2001).
On performance
Our empirical results indicate that contrary to the predictions of standard economic theory (e.g., Birchler and Butler 2007), investors process information from stock message boards inefficiently and exhibit confirmation bias. In particular, investors with stronger prior beliefs are more likely to accept confirming opinions from virtual communities. Further, we find that investors with stronger confirmation bias have higher expectations about their investment performance, but they engage in excessive trading and experience lower realized performance. A natural interpretation of this evidence is that confirmation bias makes investors overconfident and overly optimistic, which results in lower returns on stock investments. We also find that investors’ perceived knowledge negatively moderates the confirmation bias such that investors with a higher level of perceived knowledge have less motivational needs to confirm their own opinions from others.
Download the study

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