Crowdsourcing to Innovate Investing

Marketocracy: Cashing in on Collective Predictions

Steve Petersen interviews Ken Kam and Mark Taguchi, co-founders of Marketocracy, via telephone and e-mail on May 31, 2007.

Like any other investors, Ken Kam and Mark Taguchi like to invest well.

In fact, Kam himself didn't even fit the Wall Street profile or obtain an entry-level analyst job, despite his Stanford MBA. But that's why he started Marketocracy, which allows anyone to establish a portfolio with fake money in order to apply their knowledge and develop a track record of success over about five years before their decisions affect the Marketocracy Masters 100 Fund (MOFQX) that any American citizen can buy.

Steve Petersen: Analyzing financial markets is a stressful and demanding job, and professionals with highly specialized expertise and access to pertinent information make high salaries. Further, many in the financial industry tout their access to massive amounts of live economic data that services such as Bloomberg, Reuters and Thomson provide. Why does Marketocracy feel that normal folks who lack access to such information can excel beyond or at least compete with the professionals?

Ken Kam and Mark Taguchi: Information is free, but discernment about what is useful information is uncommon and good judgment of what action to take is rare.

Access to “live economic data” from services is accessible to lots of people, and these data are becoming essentially free. Earnings calls and their transcripts are available free to anyone; financial reports and economic data are online. The real value is how to interpret that information and what actions to take. It takes discernment to determine what information is useful and judgment to decide what actions to take – these are rare skills. Firsthand experience in an industry can often help give discernment, but most so-called professionals rarely have firsthand experience in the industries and companies they invest in.

Marketocracy looks for those investors that have those rare skills – the best investors. Marketocracy’s “information advantage” is knowing what the best investors find useful and knowing what actions the best investors are taking.

Q: What kind of information do Marketocracy participants have that brokers and analysts don't?

A: Most have firsthand experience working in an industry. That’s is one of the best ways to develop judgment. Since most brokers and analysts have never worked outside of the investment industry, they lack this judgment.

Marketocracy’s m100 have impressive, proven investment track records over several years, and they have statistics from making lots of precise investment decisions that give them insight into their investing strengths and weaknesses – their performance zones. These are the areas of the market and the kinds of investments that they have done well in. It helps guide them away from areas they are not good at but when they see an opportunity that is “in their zone,” or as Warren Buffett calls it, “their fat pitch,” they are willing to put it on the line.

The other thing Marketocracy members have that Wall Street analysts, brokers and mutual fund managers don’t is freedom — freedom to choose their best ideas from all stocks, not just stocks from a restricted list given to them by the firm or defined by their prospectus.

Q: Individual fund and portfolio managers rarely outperform the market. How have Marketocracy users fared against the professionals?

A: As you say, most professionals do not beat the market – 80 percent do not.

First, not all Marketocracy members are talented investors. So we would never expect all or even most of them to outperform the market. We don’t give them special powers – we’re trying to find the few that have them. Second, in a short time period, lots of people can beat the market — so we don’t look at short-term performance as an adequate comparison. We look for people who beat the market by a lot over a long period of time.

Right now I’m looking at 400 portfolios that are in or that I’m considering to add to the m100. The average age is 5 1/2 years, and during that time they have averaged an annual return of 28 percent and they’ve beaten the market, on average, by 19 percent per year.

Our m100 Index – which is the average return of the m100 – their track record AFTER they are selected and after all fees – has been 135 percent since inception versus S&P 500 index return of 52 percent and 90 percent for our mutual fund, the Masters 100 Fund.

Q: What kind of folk participate on your site?

A: We developed our Web site to track the model portfolios of professionals and anyone wanting to be a professional — but we invited anyone to participate, and the world came. We have members from 130 countries and all walks of life. Some are professionals, many want to become professionals, most have some kind of firsthand experience in an industry — but the best are all serious about investing.

Q: I reckon many participants conduct research on the companies and funds in which they invest. Do some of them share their findings and recommendations on how to act with others?

A: Some are very collegial — they see this as a great place to share ideas and learn from other investors that they respect (because they see each other’s track records). Why throw your “pearls before swine”? To some extent, they compete and some are more cautious about sharing information. Because our track records are public — members can see whether someone is worth listening to and they are more willing to share when they see that someone else with a great track record is willing to share information with them.

That’s because nobody has all of the pieces of the puzzle. So even the best investors are always looking for additional information and insights to help give them a 360-degree view.

Q: Marketocracy aggregates decisions of hundreds of individuals; for instance, on the site your main recommendations factor in the actions of the top 100 performing portfolios. How does the efficiency of a crowdsourced decision compare with that of one person or a small team of business gurus?

A: Within our group there are individuals that do better than the m100 Index, which is the average of the m100 — which is to be expected because it is the average and there will be some that do better and worse than the average within our group.

But the group as a whole does better than the average – which is the market and the market beats 80% of the professionally managed mutual funds. So, yes, our approach to crowdsourcing does do better than the average individual or small group.

However, what is different from most crowdsourcing systems is that we are making thousands of decisions over multiple years and through changing market environments. The power of our approach is about team investing — because no single manager is the “right” manager for all market environments. So over the long term, as we pass through different types of markets, we expect to see our team approach version of crowdsourcing to overtake more and more professionals mutual funds, individuals and small groups.

One thing to keep in mind is that the stock market to a large extent is a giant crowdsourced system and that the essence of great investing is knowing when to go against the crowd. We have a product we call “stock alerts” which looks for stocks when the best investors are buying a stock and the rest (or crowd) are selling. We call that a strong buy.

Q: Speaking of the top performers, what are some of the common characteristics of them?

A: 1. Good at stock picking – they have what we call a high winning ratio – the percentage of stocks that they make money on.
2. Good at trading – knowing when to cut off a loser and when to let a winner run.
3. They know when to go against the crowd. They come to different conclusions from the same information as the crowd
4. They act on their judgment – they put their money where their mouth is. A lot of people can talk a good game, but great investors get into the game.
5. Passion – they love investing
6. Many have firsthand experience

Q: A crowdsourced financial project could face ethical and legal challenges. For example, what if a participant used confidential information from his or her company to influence their decisions involving transactions that include the company?

A: Cannot prevent that — even in the real world. For us, it is with virtual money, so there is less incentive to do something illegal. And if they trade real money illegally and then also trade with us using virtual money, they are leaving an audit trail that the SEC can use against them. More important, because we don’t listen to everyone — only the ones who have proved they are worth listening to over a long period of time across lots of stocks. Only then do we put real money behind it. A cheater’s ability to demonstrate great portfolio management skills based solely on one stock — their company — is almost impossible, and their ability to influence real money investments is even smaller.

Q: How does one enforce ethical standards among a large community?

A: We have compliance rules that force members to make lots of investment decisions — not just one. So it is very, very difficult to cheat and develop a great track record. And if we discover that people have cheated, their portfolios will be disqualified.

The community does some enforcement and will call someone onto the carpet if they see something they don’t think is correct – in the end, whether a member is trying to dupe other members is always difficult to tell. Just like most of the information that is passed as “news” or “data” it may sound compelling – but our top members have proven that they have discernment in telling what information is valuable and what is not, so it is essentially a free market system and we put our votes and dollars behind the best investors.

Q: Managing a portfolio, however recreational the exercise, seems like an intense venture. What are some of the main reasons why people participate in Marketocracy — competition, education, or mere kicks and giggles?

A: We have been doing this for seven years, and we have lots of members that have been managing a stock portfolio for a long time — that is not easy.

1. To evaluate themselves and find out how good they are.
2. For the recognition to compare themselves to others and let the world know how good they are.
3. Third, to get paid – we pay the m100 and mFOLIO Masters.
4. To make it a career and establish their own personal track record.

In the investment industry, your track record is a more valuable credential than your diploma. Clients don’t care where you went to school. Track records become more value with time and alpha. The people who have established great track records consider it a very valuable asset, and they work hard to maintain it.

Q: Portfolio management sounds like an educational experience. How does participation on Marketocracy affect the users' investing savvy?

A: The realism of our system and the value of our portfolio management tools give members the statistics on their investing and feedback that helps them become better investors. And they learn from one another.

Everyone can improve with practice, but not many will ever become great investors. If you practice with real money, mistakes will be expensive so you will never make enough investment decisions to learn how to get better.

Q: Since you both maintain Marketocracy, how do the findings of your site influence your personal investing behavior?

A: Our personal and our families’ money invests in what the best investors are investing in. This is the best approach for investing we have seen, and it is going to keep getting better. It is how we invest our money.

Q: Both of you are former fund managers. From your perspective and experience, what does the future hold for professional managers with crowds like those on your sites competing with them?

A: Investing talent is a rare skill so great professional managers will always be in demand. But because investing talent is rare, much of the industry has constructed business models that do NOT deliver returns. Eighty percent do not beat the market.

Through crowdsourcing, we’ve looked to a much broader community to find investing talent than anyone has ever looked before and we’ve found lots of talent. And through crowdsourcing and the detailed investing statistics we have on everyone, we’ve created a way to leverage the individual strengths of many by calling upon them when it is their time in the sun, when they have the appropriate skills for the kind of market we’re in. Team investing!

It's going to get harder and harder for any individual manager to succeed against a team. We are getting better and better at sorting the lucky from the skilled, and managing the team so we have the right mix of skills for the opportunities the market presents us with.

We are learning who to listen to, when to listen to them and what to listen to them about.