There's A Vital Flaw In The Framework Of Investment Clubs

Imagine a group of average investors who all get together (either in person or online), share ideas, and make investments based on the collective mood of the club.

Members each do their own market research, and they participate based on the notion that a dozen minds must be better than one when it comes to stock picking.

But there's are some vital flaws in the framework.

In a 2000 study by researchers Terrence Odean and Brad M. Barber, they found no less than 60 percent of investment clubs underperformed the market by 3 percent each year.

Even individual investors fared better than clubs, earning 2 percent more returns.

They offer two reasons as to why:

Investment clubs are expensive. There are no membership fees for an investment club, but it's the trading costs that eat away at returns. Since they clubs they studied were typically drawn to smaller trades and had expensive tastes in large stocks, it simply cost each time they traded. In fact, trading costs were to blame for one-third of the clubs' overall shortfall.

They invest heavily in stocks. The other two-thirds of their losses were attributed to underperforming large stocks. "Relative to individuals, clubs tilt more toward large stocks and growth stocks," the researchers wrote. "During our sample period, large stocks underperformed small stocks (by 15 basis points per month) and growth stocks underperformed value stocks (by 20 basis points per month)."

Daniel R. Solin, senior vice president of Index Fund Advisors, drives the point home in his book, "The Smartest Portfolio You'll Ever Own."

"[Investment clubs] typically lack diversity and have a tendency to be influenced by opinions of other members of the club," he writes. "Their collective judgment about stock prices is likely to be 'unwise' and certainly not as valuable as the views of the totality of the investment community outside their group."

The bottom line: Treat investment clubs like the social gatherings they are meant to be –– not a key to beating the market.