New Kids on The Street — Lessons From Behavioral Economics
From Robinhood, to Dogecoin, to Reddit, a new breed of millennial investors are seeking alpha.
Disclaimer: I am not a registered investment advisor and the following material does not constitute investment advice. Views are mine.
The unprecedented and rapid onset of the COVID-19 pandemic throttled equity markets in the first quarter of 2020. Trillions of dollars flowed out of the market, with investors witnessing some of the darkest days on Wall Street since the global financial crisis of 2008. As states and municipalities began to institute strict lockdown measures, millions lost their jobs, and the labor market reached double digit rates of unemployment. By the end of Q1 2020, the Dow Jones Industrial Average was down nearly 25%- the index’s worst first quarter in history.
Despite the doom and gloom of Q1 2020, it quickly became apparent that certain industries and companies would weather the unraveling crisis better than others- tech stocks rallied, while companies reliant on the hospitality industry suffered. As the old adage goes, “buy low, sell high”- many wise investors saw the market lows of 2020 as an opportunity to pick up fundamentally strong companies at a discount. Not just hedge funds and money managers, either- retail investors poured into the market at an unprecedented rate.
The main avenue of course, being the millennial-friendly trading app Robinhood. With a UX reminiscent of Apple’s iOS and a revolutionary no-fee trading model (that would push industry heavy hitters like Schwab and Fidelity to ditch the traditional fee structure altogether), Robinhood is poised to democratize finance for an entire generation of young people. At the onset of the COVID-19 recession downloads of the trading app spiked, with co-founder Vlad Tenev telling CNBC that the app saw a staggering 3 million new users in Q1 of 2020 alone- dwarfing its older, more established competition in the fintech space.
For many, the COVID-19 pandemic presented an incredible opportunity to begin their investing journey with some very attractive discounts on solid blue chip stocks. Worryingly, however, many young investors were also seeking alpha through much riskier avenues of investment. Many were enticed by assets that generated index-shattering returns and tremendous media buzz- and they were willing to take on chilling amounts of risk to get a piece of the pie.
On January 4th, GameStop stock closed at a modest price of $17.69. Long considered by many to be an outdated relic of a time when physical media dominated the video game market, many large institutional investors and hedge funds were short the stock. This is a practice whereby an investor borrows shares of a stock and immediately sells them, betting on a large decrease in price before they need to buy the shares back and return them. The big boys on Wall Street were betting on GameStop to fail- according to S3 Partners, the short interest (a measure of how heavily short sold a particular stock is) of GameStop stock was over 100% of the public float in the first week of January (“float” refers to the amount of a company’s issued stock that is available for the public to trade).
Young redditors on the popular investing forum Wall Street Bets devised a strategy whereby they would pile into long positions (the act of simply buying and holding a stock for the foreseeable future) on GameStop stock to cause a short squeeze- when a sudden rise in a stock price causes those who were short the stock to buy back their shares in large volumes to cover their losses. This massive increase in demand causes the stock price to rise even further, which causes more institutions to buy back the shares they were short. This rapid rise in share prices often creates a positive feedback loop for those initiating the short squeeze, causing more and more players to enter the market and long the stock- it is a perfect confluence of herd mentality, greed, and the all-powerful fear of missing out.
In essence, Wall Street Bets had become its own hedge fund, executing a calculated attack on elite Wall Street institutions. Mets owner Steve Cohen’s fund, Point72, is said to have at one point declined 15% as a result of the GME debacle. At the height of the January 2021 short squeeze, GameStop stock was up nearly 2000%.
The GameStop situation will not be an isolated incident- we should treat it as a wake-up call, as a case study in the paradigm shift that is currently underway in finance. For the first time in history, retail investors hold real power in financial markets. At face value, Robinhood has seemingly achieved its mission of “democratizing finance for all” (for the sake of argument, we’ll ignore the practice of payment for order flow, which has been hotly debated in recent months). Robinhood’s user growth has been nothing short of extraordinary- but just as impressive is the impact their business model has had on the industry as a whole. Just as Tesla spurred other car manufacturers to accelerate their adoption of electric vehicles, Robinhood forced other brokers to adopt similar no-fee trading models nearly across the board. But if we have truly “democratized” finance in a meaningful way, there is one key question left outstanding:
What will we do with it?
If you were to take the stance of the late Vanguard founder and legendary chief executive John C. Bogle, the individual investor is best off broadly diversifying their portfolio through buying a traditional, low-cost S&P 500 index fund. With low expense ratios, tremendous tax advantages when compared to active management, and a historical return of ~10% annually, passive index fund investing certainly seems like the optimal choice for most everyone. To paraphrase Einstein, compound interest might as well be the 8th wonder of the world- if you had invested $10,000 in a traditional S&P 500 index fund in 1980, you’d be left with just over $750,000 at the beginning of 2018- a staggering 7500% return (assuming reinvesting dividends). Combined with the zero-fee trading model that has come to dominate the fintech marketplace, indexing seems like one hell of a deal for the rational, risk conscious retail investor.
The issue is that humans are flawed- we are neither rational, nor particularly risk conscious. We are easily influenced by the decisions of others, and have trouble identifying and sticking with our preferences. We exhibit systematic patterns of behavior that go against our best interest- not just as judged by an outside party- but as judged by ourselves. As behavioral economist Dr. Dan Ariely puts it, we are Predictably Irrational.
Standard economic theory, as taught in business schools across the world, suggests that humans are inherently risk-averse when it comes to making decisions. This couldn’t be further from the truth.
Don’t just take my word for it- enter behavioral economists Daniel Kahneman and Amos Tversky. In their groundbreaking 1979 paper published in Econometrica titled Prospect Theory: An Analysis of Decision Under Risk, they propose an alternate model for human decision making. Rather than being risk averse, Kahneman and Tversky suggests that we are loss averse.
At face value, this seems like an unnecessary distinction. Loss and risk seem almost synonymous. However, risk aversion and loss aversion predict two very different types of human behavior. The first suggests that humans will avoid risk at all costs- they aren’t haunted by the opportunity cost of potentially losing out on any additional gains that may result from risky behavior. The second suggests that we will avoid experiencing a loss at all costs, and are theoretically willing to take on more risk to do so.
Daniel Kahneman explains this with a brilliant exercise in his 2011 book, Thinking, Fast and Slow (in my view, the definitive guide to behavioral economics). Consider the two scenarios below, and write your answers down on a piece of paper (or a napkin, I won’t judge):
Scenario 1: Gain $900 for sure OR have a 90% chance to gain $1,000 (10% chance of getting nothing)
Scenario 2: Lose $900 for sure OR have a 90% chance to lose $1,000 (10% chance of walking away having lost nothing)
Done? If you are like most people, you picked the first option in scenario 1. While you could potentially get $1,000 from taking the gamble, the pain associated with the chance of walking away with nothing is much greater than a potential additional $100 gain. In this case, you were risk averse- but not because you feared the risk, but because you feared the loss.
If you still think this distinction between risk aversion and loss aversion doesn’t matter, let’s review how you responded to Kahneman’s second scenario. You likely chose the second option, as do most people presented with this question. In this case, the $900 sure loss loomed large in your decision. Rather than accept the lower loss, you instead chose to risk an extra $100 in exchange for the 10% chance you wouldn’t loss anything at all. You weren’t averse to risk here. In fact, you sought risk. It’s worth noting that mathematically, the expected loss from these two options is the exact same. The expected utility of a 90% chance to lose $1,000 is $900 (.9 multiplied by $1,000), and obviously the expected utility of a 100% chance to lose $900 is, well, $900. Per standard economic theory, rational individuals should be indifferent between these two scenarios. We know in practice, however, that losses loom large and the fear associated with losses can “nudge” (not to be confused with Richard Thaler!) our decisions one way or another- sometimes shooting ourselves in the foot along the way.
For investors, “loss” comes in many forms. It could very well mean the value of your portfolio decreasing due to market fluctuations (an unrealized loss) or you selling a share of stock for less than you bought it (a realized loss). More powerful, in my view, is the “loss” associated with missing out on a potential gain- the fear of missing out.
Buying a traditional S&P 500 index fund is very much like taking the guaranteed $900 from scenario 1. The index fund investor would rather allow smaller gains to compound over a long period of time than to take a chance picking individual stocks and funds for a potentially higher reward (the equivalent of taking the gamble for $1,000 in scenario 1). Let’s go back to Robinhood for a moment- when do we see a massive spike in account openings?
Ah right- when there is a potential gain looming large in the minds of retail investors. Take the spike in the first quarter of 2020- as we discussed earlier, many retail investors saw the market lows of Q1 2020 as a good opportunity to buy. The potential upside from buying otherwise solidly performing companies at a discount is massive.
In this case, individuals who were already on the fence about investing poured into the market due to loss aversion- the potential “loss” of missing out on a fire sale. This is not irrational. In fact, buying companies at undervalued prices is the core tenet of value investing. Benjamin Graham would be proud.
What about the GameStop debacle? Surely the first thing that grabbed your attention when looking at the graph above is just how large the spike in account openings is in January of 2021 when compared to Q1 2020. This too can be explained by loss aversion. While many investors saw the market lows associated with COVID-19 as an opportune time to build a portfolio, it is understood that the gains associated with this will present themselves over a long period of time, with modest gains along the way (as the economy recovers and the market rebounds, whenever that may be).
In the case of GameStop new millionaires were minted overnight (often through spine-chillingly risky options strategies), and public forums made these gains very visible. Whether it be through threads on the Wall Street Bets subreddit or Jim Cramer’s impassioned monologues on Squawk on the Street, the spotlight was on these millennial investors. The fear of missing out on astronomical gains- the fear of a loss- caused a new generation of investors to stick their heads and wallets into the game, taking on much more risk than they might have realized in the process. For some, this strategy of pouring their savings accounts into GameStop stock made them richer than God.
Some lost the shirts off their backs. As John Bogle said, what works for some cannot work for all.
The democratization of investing through no-fee trading and intuitive mobile platforms is perhaps the greatest personal finance innovation of our time. This creates a tremendous opportunity for ordinary people to build wealth through investing for their future. Some platforms even offer fractional share trading- buying fractions of a stock rather than the whole thing. This allows investors at any income level to own pieces of companies like Amazon and Google, which typically trade for thousands of dollars per share.
Unequivocally, equal access to investing is one of the cornerstones of ensuring that our capitalist economy works for everyone. By the same token, retail-friendly trading platforms like Robinhood have also made gambling in the market much easier than it was before. It seems that the democratization of finance, despite its apparent benefits, is also bringing the flaws in human decision making to the surface.
Funds, banks, and other financial institutions, while run by irrational humans, are theoretically governed by investment strategies, fiduciary responsibility, and regulatory considerations. Individuals, on the other hand, are free to make decisions as they please and shoot from the hip. If Kahneman and Tversky are right, and humans are truly biased to make predictably irrational decisions when faced with risk, and are subject to FOMO-driven herd mentality due to loss aversion, then the flood of retail investors into the market is bound to make it way more volatile. The stock market isn’t a casino, but it can be if you treat it as one- and there’s one thing we know for certain:
The house always wins.
