NEW YORK -- Just as YouTube prompted a deluge of cat videos, so social media seems to stimulate more trading in the financial markets. But unlike the cat videos, it isn't all laughs: The phenomenon seems to leave traders worse off than before.
In other words, social media boosts the quantity of trades but not the quality.
The findings are detailed in a working paper from the Federal Reserve Bank of Cleveland titled Facebook Finance: How Social Interaction Propagates Active Investing, which was published in October. The authors, Rawley Z. Heimer from the Cleveland Fed and David Simon from Berkeley Research, analyzed the trades of 3,117 retail foreign-exchange traders and their social interactions from January 2009 through early December 2010.
All traders included in the study used one of 53 different currency-exchange brokers, which the authors don't identify. Communication via social networks "supports active trading, even though the network reveals the low success rate of retail traders," the report found.
The researchers used information from what they call a Facebook(FB) - Get Report -style social network that didn't provide trading services itself but did record data. (To maintain the organization's anonymity, they call it myForexBook.) Researchers were able to get details of the trades, time-stamped to the second, as well as records of interactions between the traders, which enabled them to determine whether there were "clear links between trading and social activity."
One disturbing finding is summed up with the following statement: "A trader's activity increases when peers perform well and increase communication," according to the report. It's as if a gambler sees a winner at the next roulette table in a casino and, consequently, decides to risk more.
The report talks of "bias towards positive returns," with individuals trading 20% more if the others in the network had profitable returns. "The effect is stronger when traders receive messages from others and at times when there is more conversation in the network," the report says.
It doesn't work in reverse, apparently because losses in the social network don't reduce trading. Plus, traders aren't inclined to talk much about losing money, the report finds.
Keeping a calm outlook when trading is vital to success, as regular traders probably know. So piling into the market when others are doing well may not be the optimal strategy -- it tends to insure the person making the trade is more emotional.
Likewise, keeping silent about losses while bragging about gains probably isn't helpful to the community -- but helping the community isn't generally the point of trading.
While the higher number of trades is great for companies providing the services, it's not that great for the traders themselves. Those in the study didn't do well at all: The median weekly returns were zero, which means half of them lost money each week. The mean returns were negative.
One corollary: The increased trading also yielded a 25% increase in volatility, on average. Most investment professionals see volatility as synonymous with risk, and when volatility rises by a fourth, that's a lot more risk.
So there's the result: no better returns, but higher risk. I'd say that's not a winning combination.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.