Dangerous unity: how social media is worsening stock trading results

Retail investing has undergone a revolution in recent years. Small traders are no longer disorganized individuals, sometimes with a legion of names. Telegram channels with signals, threads on Reddit, profile forums, and "auto follow" functions in brokerage applications have created the illusion that collective intelligence can beat the market.

The logic seems ironclad: if thousands of people buy a stock at the same time, it will rise. If we all discuss the company's report together, we will find something that Goldman Sachs analysts missed. The "mob vs. Wall Street" narrative, fueled by the GameStop saga, has become the main tale of the "from dirt to dukes" genre for the first half of this decade.

But what if this cohesion is not an advantage, but a vulnerability? A new study by Bundesbank experts shows: the more you focus on the actions of other private investors, the more you lose, effectively shifting money from your pocket to the pockets of market professionals.

The study is based on Kyle 's classic 1985 model. It has three types of players: informed professional traders, a market maker who moves price in response to a general flow of orders, and retail investors whose trades are considered noise not directly related to fundamentals. In the basic version of the model, retail trades in an uncoordinated fashion: some buy, some sell, and this noise is relatively harmless to the pros.

The German economists added to this scheme one parameter critical to the social media era, namely the correlation of retail investors' market orders when thousands of people simultaneously run into the same securities because they are discussed in chat rooms and recommended by finfluencers.

To get out of pure theory, the model is calibrated with real data from the broker Robinhood on how synchronously and at what moments retailers acted "in formation". This level of correlation is substituted into the model and the two worlds are compared: without and with coordination.

The study's main conclusion is very specific: according to the calculations, flash mob trading increases retail investors' losses by an average of 5.1% compared to a scenario where they would have acted independently of each other.

That is, if your annual average market return should have been at 10%, it is halved because of the coordination factor.

Why is this happening?

First, because of price distortion. When a crowd of retail investors simultaneously "crowds" into one asset, they detract its price from its fundamental value. The stock rises not because business has gotten better, but because of an influx of buyers.

Second, because of predictability. For market makers and professional participants, the direction of the crowd is a gift. They see this flow and, more importantly, know that price will inevitably return to normal. Institutional investors use this burst of liquidity to lock in their profits on the crowd or open short positions at the peak of the frenzy.

Paradoxically, the authors note that this is a good thing for the market as a whole. "Social trading" increases market liquidity and pricing efficiency. The only problem is that this efficiency is paid for by losses of retail investors.

There have been several academic papers published in recent years on how social media and social trading are changing retail behavior.

For example, the 2024 study, data from which the Bundesbank also took into account, analyzed millions of transactions of Robinhood brokerage clients. The conclusion is unambiguous: the "coordination" of retail traders leads to systematic losses for retail investors subject to herd mentality - their portfolios show a return penalty of about 3.8 percentage points annually.

Another study examining the impact of increased attention to individual securities in the r/wallstreetbets subreddit on private investor returns found that positions opened at times of maximum hype, on average, generate about 8.5% losses for as long as the investor holds those securities in the portfolio, while for all other investments the average result remains positive.

Finally, a recent paper on meme stocks and Generation Z investors shows that volatility spikes in stocks like GameStop or AMC coincide almost perfectly with spikes in Reddit and TikTok activity. The behavioral drivers are clear: fear of lost profits, herd behavior, and the hope of "making a profit in one go".

Opinion leaders are actively helping those who are not yet ready to decide to participate in the "group race" on their own. An experiment by the Securities Commission of the Canadian province of Ontario has shown that finfluencer content significantly encourages people to make deals: in an online simulation, almost 24% of participants who saw posts stylized as publications of finfluencers bought the promoted asset, compared to about 7% in the control group, which was not shown these publications. At the same time, regulators themselves note that the quality of such advice is highly heterogeneous, some of the authors are not qualified or act with a direct conflict of interest, and investors who trust finfluencers are much more likely to fall victim to fraud.

Social media and social trading have indeed changed markets: they have made them noisier, more emotional and in some ways even more efficient. But almost all serious studies say the same thing: collective intelligence in its current form works in favor of the market and professionals, not in favor of the individual private investor.

Therefore, the main practical conclusion is simple. Keep your distance from the collective euphoria, treat any "signal" from the chat room as a reason for your own analysis, not as a command "go ahead". It is not as exciting as meme stocks, but according to all academic calculations, this strategy has a much better chance of preserving and increasing capital (or at least not losing it).

This article was AI-translated and verified by a human editor