Financial recommendations on Reddit, stock returns and cumulative prospect theory

Area of Science:

• Finance
• Behavioral Finance
• Social Media Analysis

Background:

• Social media platforms, particularly Reddit's finance subreddits (wallstreetbets, investing, stocks), have become influential in stock market discussions.
• Retail investor behavior and the impact of online communities on investment decisions are areas of growing research interest.

Purpose of the Study:

• To evaluate the investment performance of stocks recommended on major Reddit finance subreddits.
• To explore the underlying behavioral factors, using Cumulative Prospect Theory (CPT), that drive investor attraction to these social media-driven stock recommendations.

Main Methods:

• A quantitative strategy was developed, buying stocks recommended on Reddit weighted by daily post volume.
• Portfolio performance was assessed using metrics such as average returns, risk, Sharpe ratios, and alphas relative to common risk factors.
• Cumulative Prospect Theory (CPT) was applied to analyze investor valuations and preferences.

Main Results:

• The Reddit-based strategy yielded higher average returns but also significantly higher risks, resulting in unfavorable Sharpe ratios compared to the market.
• The strategy showed positive but insignificant short-term alphas and negative significant long-term alphas, suggesting "meme stock" inflation rather than fundamental value.
• CPT-based valuations indicated that the Reddit portfolio was more attractive to investors than the market, despite the poor risk-return profile.

Conclusions:

• Stock recommendations on popular Reddit forums, while potentially leading to short-term gains, do not offer sustainable long-term investment value.
• The persistent appeal of these recommendations, even with unfavorable risk-return ratios, can be explained by investor preferences for risk and potential gains as modeled by Cumulative Prospect Theory.
• Understanding behavioral biases through frameworks like CPT is crucial for comprehending investor behavior in the context of social media-driven financial markets.