Does r/WallStreetBets Stocks Generate Excess Returns?

Thanks to the prevalence of COVID-19 in our everyday lives, it's getting increasingly difficult to return to normal for most people. While I've used this additional flexibility to pick up on old hobbies (gaming, music, etc.), others have used theirs to learn about financial markets. Knowing that I work in finance, some of my friends have reached out to me for financial pointers, while others have opted for the convenience of reading r/WallStreetBets.

You may be asking, why am I -- someone who would be considered a "sophiscated investor" -- would even be interested in a platform such as r/WallStreetBets? For those of you who don't know, I've written a piece about the subreddit last year. However, it was never clearly explained the buzz around r/WallStreetBets.

Due to the pandemic (the financial insecurity and flexibility it brought to millions of people), as well as the stimulus checks provided by the government and the rise of free trading platforms such as Robinhood, a lot of people who would typically not dabble with stocks are having fun with the stock market. They're also investing in all sorts of zany things like Dogecoin and GameStop. Institutional Investors (the "smart money") and the veterans in the financial media fail to understand this, and they're generally condescending and negative towards these new brand of retail investors.

They call them idiots for taking risks in cryptocurrencies; they call them fools for believing companies in dying industries with falling revenues are great investments [2]. From this, the term "Dumb Money" was used to describe this new breed of investors; "DOGE/GME to the moon," they frequently chant, much to the disdain and confusion of legacy investors and their friends in the legacy media [3].

Recognizing the condescension, these retail investors decide to take their agency back using the self-described label known as Retards. Retards, if you don't know, is a rearrangement of the word tradeRS. Since they're not considered legitimate tradeRS in the eyes of the investment community, they'll just call themselves Retards, which is an anagram designed to reclaim the agency taken from retail investments. Sure, they may be considered "Dumb Money," but they're going to make the investment decisions they want to without the influence and manipulation of institutional investors and their friends in the financial media.

This is largely the energy behind drama involving r/WallStreetBets and the rest of the investment community.

Are r/WallStreetBets Stock Picks Even Any Good?

It is generally assumed -- rightly or wrongly -- that if you have a background in finance, you know what you're talking about. The barriers required to work within the industry seem to justify the claim. The most well-known front-end finance jobs require a bachelor's degree at an accredited four-year university, along with passing, at minimum, the Securities Industry Essentials Exam (or SIE) and either a FINRA Series 3 or 7 Exam.

Jobs that are more analytically driven, such as Actuaries, may require candidates to have a statistical or mathematical background and pass several SOA (Society of Actuaries) Exams. While Quants (which is my domain) typically don't require examinations; however, some positions do encourage and require candidates to have at minimum a Masters of Science in a STEM field.

So yes, it may be easy to see why people on Wall Street are considered "Smart Money."

However, this doesn't mean you need education and fancy certificates to make good investments. Warren Buffett, one of the greatest investors alive, began to invest on his own when he was only 11-years-old. While the man would never even look at any of the companies r/WallStreetBets are investing in, he established a system that allowed him to make sound investments using the resources available at the time; namely, a book published by Benjamin Graham called The Intelligent Investor. Speaking from personal experience, I started learning about finance and economics on my own time before I enrolled in university to pursue it as a career.

Today, the resources available to help retail investors are potentially endless. Most of what you'll find on the internet is bunk; however, you can find invaluable information if you know where to look.

This project aims to see if the Retards at r/WallStreetBets know where to look. Are they seeing things we aren't seeing or just larping as wall street speculators?

Excess Return and the Capital Asset Pricing Model

I'm not going to discuss what makes an investment good or bad, which is based on different investment philosophies, income goals, etc. What is important is that we determine whether or not the investment selected by r/WallStreetBets has the potential to outperform its benchmark, and if they are, what is the optimal portfolio (a portfolio maximizes return and minimizes risk). We can this out by measuring what is known as excess returns.

Excess returns, also known as alpha, is a measure of how much a fund has under or outpeformed the benchmark against which it is compared. It is calculated under the Capital Asset Pricing Model (CAPM).

This important financial return metric allows investors to compare sets of funds against each other, in order to see which fund has generated greater excess returns. Of course, there are a number of other measures of perforamnce and so while one investor may favor a fund with high excess returns, others may view the same strategy as too risky.

By using excess return (alpha) and volatility risk (as described by beta), investors can evaluate a fund's total performance on a risk-adjusted basis.

Excess returns measure a portion of a fund's return that's not explained by overall market returns. As such, analyzing excess returns can help determine whether outperformance is attributed to a portfolio's manager's investment skills or simply as a result of movements in the stock market (as all stocks tend to be positively correlated).

Seeking Alpha

Alpha, or Jensen's Alpha, quantifies the excess returns obtained by a portfolio of investments above the returns implied by the Capital Asset Pricing Model (CAPM).

The formula is denoted as follows:

\[\alpha = r_{p}-\big[r_{f}+\beta \big(r_{m}-r_{f}\big)\big] \]

where:

  • \(r_{p}\) = Portfolio Return
  • \(r_{f}\) = Risk-Free Rate
  • \(r_{m}\) = Expected Market Return
  • \(\beta\) = Portfolio Beta

The value of alpha -- the excess returns -- can vary. A positive number signal's overperformance relative to the benchmark, while a negative number signals underperformance. Zero (or a number close to zero) shows a neutral performance; the fund tracks the benchmark.

The CAPM formula utilizes the risk-free rate to account for risk. Therefore, if a given security is fairly priced, the expected returns should be the same as the returns estimated by CAPM. However, if the security were to earn morethan the risk-adjusted returns, the alpha should be positive.

Building a Portfolio

Result

We will construct a portfolio using popular stocks from the WallStreetBets community. In July 2021, I decided to find the most talk-about stocks in the r/WallStreetBets subreddit and narrowed the list down to 20 of the most popular equities on the platform. Six of these assets have recently gone public, and they will be excluded from the experiment.

We're also going to include popular cryptocurrencies, such as Bitcoin and Dogecoin.

Descriptive Statistics (Risk & Return)

In portfolio management, we are interested in annualized returns in order to compare different instruments or portfolios. Simple aveages only work when the numbers are independent of each other. As a result, we need to the consider amount of investment lost or gained in a given year is interdependent with the amount from the other years under consideration because of compounding. Since the method to calculate return is an estimation, we will use the term expected returns (\(E[R]\)).

Considering that the data we have extracted is daily, we need to calculate the respective annual returns from 2017 - 2022. Once we have the annualized returns, we will use log returns. When comparing simple returns with log returns, while simple returns allows us to check the profitability of an instrument since the beginning of a year, log returns allows us to see the difference more cleanly to show how instruments are modeled in continous time.

[2] The New York Times | 'Dumb Money' is on GameStop, and It's Beating Wall Street at Its Own Game

[3] Quartz | Reddit and Robinhood gamified the stock market, and it’s going to end badly

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Andre Sealy
Data Scientist / Researcher / Writer

My research interests involves Quantitative Finance, Mathematics, Data Science and Machine Learning.