“Robinhood investors’ evident lack of skill in aggregate is consistent with commission-free investors behaving as uninformed noise traders,” reads a new academic paper by Oklahoma State University’s Gregory W. Eaton and Brian S. Roseman, and Emory’s T. Clifton Green and Yanbin Wu.
The recent debate over whether the Robinhood set, “informed” by WallStreetBets and other manifestations of “social trading,” can beat the pros or otherwise “stick it to the suits,” is absurd on multiple fronts.
As WallStreetBets discovered during the GameStop saga, unintended consequences can undermine the message, casting considerable doubt on the viability of the “movement” in the process. Distressed-debt investors made hundreds of millions during the two-week soap opera, for example. And if you’re in the “creative destruction” camp, you might ask yourself whether these unintentional bailouts are a good thing. If it’s bad for the Fed to prevent the purging of misallocated capital (by backstopping the corporate credit market), why is it good for retail investors to effectively do the same thing? Further, legions of Robinhood adherents are now acutely aware of the fact that the company’s name has always been an oxymoron, as one recent guest post reminded the retail crowd. In a sense, retail investors are not Robinhood’s “customers.” Rather, they are Robinhood’s product.
But beyond any of that, the notion that Robinhood (or Reddit or Twitter) “democratized” markets is just wrong. Market democratization is yesteryear’s phenomenon.
The proliferation of low-cost ETFs and the epochal active-to-passive shift meant that “regular” people no longer needed to pay exorbitant fees to active managers who very often underperformed benchmarks. Eventually, fees on index funds tracking broad benchmarks and simple strategies (e.g., high dividend baskets) fell to essentially zero. I’ve argued that the old adage about “too much of a good thing” applies to passive investing. But setting that debate aside, there’s no question that the low-cost, index investing revolution was one of the most beneficial developments in the history of capital markets (unless you’re an active manager, of course).
The fact is, it’s hard to beat benchmarks over very long periods of time. When you factor in high fees, it becomes even harder. Sure, some people can do it, but post-financial crisis, when the Fed and its counterparts across the developed world instituted policies that served to prop up asset prices in apparent perpetuity, the task of outperforming the simplest of simple ETFs (e.g., SPY) after fees, became Herculean for active managers and hedge funds.
In August of 2019, assets in US index-based equity mutual funds and ETFs surpassed assets in active stock funds (figure below).
That was the “democratization” of markets. Reddit, Robinhood, and the like, is just gamification. Retail investors can now “play” the market like a slot machine.
As many politicians have been keen to point out over the past two weeks, hedge funds and other whales have always treated markets like a casino, and they always will. And no matter how many congressional hearings you hold, they will never sit at the same table with, or play by the same rules as, retail investors. They will always enjoy better access and better odds.
That latter assessment is fatalistic (and somewhat depressing for this new breed of young investor), but as noted above, there is a way around it. If you’re a young investor and you really want to beat “the system,” one idea is to save up, say, $10,000 and start a Vanguard account. As much as this will irk some of my readers, most professional investors and traders didn’t beat the broader market in 2019 and 2020. How could they? Just look at the returns:
The S&P returned 31.5% in 2019 and 16.3% in 2020. And 22% in 2017. And 12% in 2016. And 13.7% in 2014. And 32.4% in 2013. And I could go on. For all the press, 2018’s decline was just 4.3%. 2015, another “bad” year by post-GFC standards, saw the S&P return 1.4% despite the earthquake caused by the yuan devaluation.
Show me a “trader” or a fund manager that claims they can consistently beat those types of numbers and I’ll show you someone who is probably lying to you. When you net out the fees you’d have to pay to retain that hypothetical person’s “services,” they are almost guaranteed to underperform over long periods.
That is, of course, a generalized assessment. At any point in time there will obviously be some “star” fund manager who grabs headlines, and there are a handful of folks who, over time, have proven adept at delivering something like consistent outperformance. But that’s the exception, not the rule. And, again, anybody who tells you different is lying to you.
Bottom line: The democratization of markets happened years ago. You can track any number of benchmarks and/or simple, safe strategies using exchange-traded products that cost basically nothing. That’s the democratization of markets. And you can reliably leverage it to outperform the “pros” over long periods, with the obligatory caveat that past performance is no guarantee of future results.
By contrast, what you’ve seen recently is just the expansion of the casino for those inclined to treat markets as an avenue for gambling. Now, the casino is open to everyone at no cost to trade, unless of course you count the value of your order flow which, if you’re a retail investor, you probably didn’t even know had any value, which is why you didn’t ask any questions when brokers started telling you that you could trade for free.
This brings me back to the academic paper cited here at the outset. The authors note that Robinhood’s “mean investor is 31 years old with average account balances between $1,000 and $5,000.” That compares to 50 years old and $47,000 in another, “heavily studied US retail brokerage sample from the 1990s.”
There is little question that a 31-year-old with $5,000 would be better off in an index fund than day-trading on Robinhood, assuming he/she intended to hold for a long period of time. But that begs the question. Because if you wanted an index fund, you probably wouldn’t be on Robinhood in the first place.
The authors also note that their “analysis of website traffic reveals that the most popular Robinhood FAQ topic is ‘What is the stock market?'” That’s reminiscent of after-the-fact searches for “What is the EU?” following the Brexit vote. Notably, the questions investors on more traditional platforms “ask” are at least a bit more nuanced. The authors note that on Charles Schwab, E*Trade, Fidelity, and TD Ameritrade, sections on “What are Stock Splits” and “What are Puts and Calls” are more likely to be viewed. The implication is that if you’re trading with, say, Fidelity, you already know what stocks are. Irrespective of whether you’re young and/or don’t have much money.
It won’t surprise you — or maybe it will, given ostensibly conflicting studies and media coverage — to learn that Robinhood ownership might not be related to future performance. Additionally, it appears that Robinhood and WallStreetBets may actually be behind the retail curve. Here’s a passage from the paper:
Recent research suggests that retail trades in aggregate positively predict future returns and earnings surprises (Kaniel et al., 2008; 2012; Kelley and Tetlock 2013; Boehmer et al., 2020; Farrell, et al., 2020). In contrast, we document that firm-level changes in Robinhood ownership are at best unrelated to future returns, consistent with uninformed trading and more similar to early studies of retail investors (e.g. Barber and Odean, 2000). Our research also adds to the literature that examines the effects of financial social media on financial markets. Several studies find evidence that certain types of social media can provide investment value (Chen, et al., 2014; Jame, et al., 2016; Farrell, et al., 2020), whereas other work suggests that social media may intensify behavioral biases and spread stale news (Heimer, 2016; Cookson, Engelberg, and Mullins, 2020). We find that the Reddit WallStreetBets forum, which is often comprised of brief posts, nevertheless strongly predicts future zero-commission retail trading, while coinciding with or lagging aggregate retail trading, which may help explain why Robinhood investors underperform relative to other retail traders. In particular, aggregate retail volume leads WallStreetBets mentions by a couple of days and therefore also leads Robinhood activity by nearly a week. The delayed pattern suggests that Robinhood investors trade after other retail traders in aggregate, which may help explain why return predictability of trades from the two groups differs.
It sounds as though WallStreetBets does, in fact, prompt trading on Robinhood, but that activity is delayed versus broader retail activity. You could draw speculative, nefarious conclusions from that, but the authors don’t, so I won’t either. Suffice to say that being too late to the trade isn’t a good thing. Being too late to a pyramid scheme is a sure way to lose money.
The section which describes the results of statistical tests run by the authors is not flattering for Robinhood. Or at least not for Robinhood’ers, if you will. Consider this:
The central result.. is that changes in Robinhood ownership do not positively predict future stock return at alternative horizons up to 20 days. The estimated coefficients on Robinhood ownership with no control variables are generally negative and none are significantly positive. Controlling for other return variables and firm characteristics does not change the inference. Thus, there is no evidence that Robinhood investors on average are informed about future returns. This result is in a dramatic contrast to the predictability of order flow from a broader set of retail investors. Across all specifications, aggregate retail order imbalances positively and significantly predict future stock returns, consistent with prior findings. In summary, although retail trades in general positively predict future returns, Robinhood investors on average appear to behave as noise traders.
It may, in fact, be fruitful to study and parse retail investor order flow when it comes to predicting future returns. But when you isolate Robinhood, the benefits of that analysis are less clear, to put it generously.
Importantly, the authors’ approach isolates effects on market quality using platform outages. To do that, they bring in WallStreetBets. Here’s how:
Analyzing the market effects of Robinhood platform outages requires a forecast of which stocks Robinhood investors would have traded in the absence of the outage. Our main proxy relies on message board activity from the Reddit WallStreetBets forum (r/wallstreetbets), which has “become synonymous with retail zeal in the pandemic age” (Kochkodin, 2021). We also consider measures of lagged Robinhood trading activity to proxy for expected trading during outages. We confirm that mentions on WallStreetBets as well as lagged ownership changes strongly predict future changes in Robinhood ownership in general, and we explore the effects of platform outages on stocks with expected Robinhood trading.
This is where the analysis gets especially interesting and, in my view, especially damning (the authors don’t put it that way — I’m expressing my own, subjective interpretation). Consider a few additional passages from the paper:
An influx of noise traders could potentially enhance or harm stock market liquidity. In canonical adverse selection microstructure models such as Glosten and Milgrom (1985) and Kyle (1985), an increase in noise trading reduces the likelihood that market makers face informed traders, which should lead to improved market liquidity. On the other hand, inventory risk models such as Ho and Stoll (1981) and Grossman and Miller (1988) emphasize that market makers are concerned about fluctuations in their inventory’s value, which may be magnified by noise trading shocks. In this setting, an increase in noise trading may result in reduced liquidity.
[…]
Taken together, the findings support the view that zero-commission traders have negative effects on stock market quality, consistent with behavioral noise trader and inventory risk models.
Our analysis indicates that during platform outages when zero-commission trading is restricted, stocks favored by Robinhood users experience reduced bid-ask spreads and price impacts as well as lower return volatility, suggesting that Robinhood investors may negatively impact market quality. These results do not appear to be due to market conditions on days with abnormal activity. In particular, pseudo-events that are assumed to occur one hour after the actual outage, are not associated with changes in market quality. Further, after removing stocks with intense event-day WallStreetBets activity, outages early in the trading day, and outages during the COVID-19 turbulence of March of 2020, we continue to find that market quality improves for Robinhood stocks when outages restrict zero-commission traders.
Zero-commission trading depends on payment for order flow arrangements between brokers and high frequency traders, where HFTs pay brokers a fee for the opportunity to act as market maker for their orders. During platform outages, we find significant evidence that HFTs pull back from stocks favored by Robinhood investors. To capture the effects of zero commission traders on financial markets that are distinct from the mediating role of HFTs, our final tests partition Robinhood-favored stocks into those with high and low HFT activity. During platform outages when Robinhood investors are restricted from trading, we find the strongest improvement in market quality for stocks that are popular among Robinhood investors but are not actively traded by HFTs. In contrast, stocks that are both popular among Robinhood investors and actively traded by HFTs see their market quality degrade. The evidence suggests that the lower market quality associated with zero-commission investors is best explained by uninformed trading rather than predatory HFTs.
All of this paints an unfavorable picture for Robinhood traders. According to the results of this study, they are less informed than other retail investors, trade a week behind other platforms (due possibly to the intermediary role of WallStreetBets), don’t have a good overall track record, and may adversely affect liquidity and market conditions more generally.
If you’re looking for quick takeaways from all of the above (and I realize it’s quite a bit to process), I’d suggest three things.
First, Robinhood and social trading didn’t democratize markets. Passive investing did. And while the passive investing revolution risks bumping up against the old “too much of a good thing” adage, it was (and is) an unequivocally positive development. The gamification of trading and the blurring of the line between gambling and investing among unsophisticated investors is an unequivocally negative development.
Second, beating hedge funds and professional traders needn’t be a “movement” or couched in confrontational, revolutionary terms. If what you want is to claim “victory” over the pros, one good way to do it is to buy an index fund from Vanguard (or a similarly revered firm), wait a decade, and then compare your performance to a cross-section of hedge fund returns after fees. Chances are, you’ll have done better than many of them. Relatedly, I can almost guarantee that your favorite “pro” didn’t outperform the cumulative return of the S&P over 2019 and 2020, especially not for a hypothetical long-term investor who bought during the ~19% pullback in Q4 of 2018.
Third, Robinhood (and, indirectly, WallStreetBets) may be deleterious to the health of markets and, more importantly, to the psychological well-being of the people who frequent those platforms.
Draw your own conclusions. As long as they’re consistent with mine. (I’m just kidding. Sort of.)
Great column! I will keep this for when young relatives ask how to make money in the market.
I think it’s important. Mostly because it’s becoming harder and harder for regular folks to separate the “good” guys/gals from the “bad” guys/gals.
I get a lot of email from people who are signing up for (relatively) expensive “newsletters” and “services,” and now we’ve got Reddit claiming to be the savior of the “little guy,” and then there’s Elon Musk (who was still tweeting about Dogecoin on Sunday), and just on, and on, and on.
Short quotes and properly contextualized/paraphrased citations from good analysts (especially those with a knack for summarizing macro narratives) are both useful and additive, which is why I, like Bloomberg or FT or WSJ, utilize them sparingly in general market coverage.
But totally separate from short sellside quotes, this cacophony of people claiming to be buysiders on Twitter, speculators, charlatans peddling grossly expensive monthly “services,” Redditors, VCs, etc., etc., is not a good thing. It’s overwhelming for most people.
And I think another thing that gets lost is this: Even for investors with what everyday people would consider to be sizable amounts of investable capital, the best strategy is still some manifestation of Occam’s razor. I mean seriously, think about it. Let’s say you have $2 million. Where are your odds best when it comes to growing that? Spread out across several low-cost funds from Vanguard, T. Rowe, and Fidelity, or trying to deploy it across some complicated hodgepodge of strategies you gleaned from who knows where?
I just think people have a distorted view of the world sometimes. And I get it, because I’ve been there. When you have what, to the vast majority of humanity, would be “a lot” of money, it’s sometimes easy to lose track of the fact that when you move out of the regular world context and into the context of markets, that amount no longer counts as “a lot.” If you lose track of that, you can suffer from delusions of grandeur.
Don’t get me wrong, if you’ve got $100 million or something, or you have clients, or you have so much invested that you have legitimate daily hedging needs, etc., etc., then sure, absolutely: You’ll want (and, indeed, you’ll require) more out of your investing life than some simple funds. Depending on just how rich you are, you may even need sophistication that goes well beyond what can be obtained by some local office let alone from Mary, your friendly Merrill rep down the street.
But if that’s you (i.e., if that last paragraph applies to you) you know it. Or you should know it. And I suspect that’s where the problem comes in for a lot of folks. They get $3 million (or whatever) and think they’re “players” or otherwise need to “make moves.” That’s when the trouble starts. 🙂
I mentioned in this comment section this summer that I may have been better off buying 10% a week of SPY starting April rather than stock picking. I was on the early side of some lucrative trades so overall I have done better but had to work at it. I am sure I am not the only elder who dove into deeper trading this downturn. I have learned much and have enjoyed it but will simplify things by July. That will mean keeping many dividend stocks I got at a bargain and gravitating to more tradable funds.
I thank you Mr. H and will continue my education here and at Seeking Alpha, etc. I have always enjoyed Macro Economics and this article goes a long way toward letting me know the kids will be alright. My non-fictitious Niece is now asking about educating herself about markets. Dot.com kicked many of the young back when and they have become mature investors spooked into passive and better off for it. It is hard to argue with success, which is now, as always, rear view mirror.
Excellent post.
Anecdotally, 2/3 of my kids bought IVV and KO with their stimulus checks in a TDA account, so not all Zoomers are Robinhooders.
Finally, I timed myself and my read time was 15- but I had to reread several sections twice to absorb.
If one assumes that these new traders learn and improve (by doing less, say), then shouldn’t the outlook improve for this investor cohort? Certainly there could be churn on the Robinhood platform, making it a perpetual noob mecca. I’m not so sure though, that the ‘someone’ who has to underperform the market will remain the Robinhood trader. There’s clearly plenty of underperformance in the 4.2 trillion of active management already.
As a final note, index fund investing isn’t necessarily rational for a large part of the American public. As you have wonderfully covered over the years, a large part of the public (investing or not) simply don’t have enough money to to meaningfully compound, even if they hit decent % savings goals (which they cannot). Getting 6 or 7 doubles over an investment lifetime just ain’t that great if you start from 1k. The rational and justifiable play for these people is a lottery ticket stock or momo-chasing.
If one assumes that these new traders learn and improve (by doing less, say), then shouldn’t the outlook improve for this investor cohort? Certainly there could be churn on the Robinhood platform, making it a perpetual noob mecca. I’m not so sure though, that the ‘someone’ who has to underperform the market will remain the Robinhood trader. There’s clearly plenty of underperformance in the 4.2 trillion of active management already.
As a final note, the index fund investing isn’t necessarily rational for a large part of the American public. As you have wonderfully covered over the years, a large part of the public (investing or not) simply don’t have enough money to to meaningfully compound, even if they hit decent % savings goals (which they cannot). Getting 6 or 7 doubles over an investment lifetime just ain’t that great if you start from 1k. The rational and justifiable play for these people is a lottery ticket stock or momo-chasing.
Hard not to agree with most of your column. Sort of.
That said, the vested interests of the different groups you write about are simply not the same. Active managers, be they hedge funds or broader diversified asset managers, seek to beat their broad index benchmarks primarily because those track records lead to more inflows of AUM. Passive managers are really no different: how many hundreds of thousands “benchmarks” have been created by the financial services industry for ETFs to track and ideally beat?
Also, just “beating the pros” shouldn’t be the end in itself. Most retail clients, with or with out an advisor, want to invest toeventually achieve individual goals, one of which is not typically beating this or that PM or analyst. You can find lots of active managers who outperformed their benchmarks in 2000 or 2008 whose clients could not achieve those goals.
The real threat to markets is financial illiteracy. Robinhood and WallStreetBets are just symptoms of that threat.
Good article and timely given what’s happened over the last month. My son was showing me various parabolic graphs and asking if those stocks or “investment instruments” for lack of a better expression (think Bitcoin) were good places to start investing. I told him to go find other places this happened and what happened after. GME was a quick life lesson for him along with his other research. No such thing as a free lunch.
For almost every young adult who has only a small sum to invest, the time and effort required to be a successful active investor would be better spent getting more education, a better job, and advancing in a career.
Start with $5K. To get to $80K, you need +1500% return (four consecutive doubles) of the entire portfolio. To maintain $80K/yr income, you need +100% annual returns for your lifetime. Assignment #1 should be to spend a week researching the top-performing investors/traders and list those who achieved that.
JYL- You are exactly right- that plus learning to live a happy life below your means. Living on less than you COULD spend has some stress reducing elements that can bring you to the point that allows you to focus on what can truly bring you happiness.
Are they victims? Is the behavior of this cohort just more evidence of us being yield starved and going out on the curve for returns?
Another aspect that is easy to forget about when reading articles about this cohort of “investors” is that they have grown up not knowing what it is like to get 5% (or six or seven) on a CD. CDs as an “asset class” (they’re not, just saying) are no longer available to the emerging, retail investor.
Thought experiment: 30 to 50% of this cohort would be happy to receive 5-7% annual returns in exchange for almost zero risk to their capital.
Hypothetical: The majority of this cohort will get it and eventually just go in on SPY…then we have a 5-year, corrective period where markets revert to within some range of historical norms. …more academic articles ensue about how we are all just fodder.
Great article and many great comments.
Today, no investor segment can claim to be pure. Like many areas of life, there is too much emphasis on the desire to beat the system, something or someone else. And, there is too much emphasis on the investing process, e.g., playing vol or liquidity, gamma, etc. – seemingly everything but the quality of the company and fair gain. Ever thus.
Great comments. I would add that there is value in losing, if you really want to learn, instead of being faddish. Also it is not excessively hard to learn about and follow a diverse few select companies over a period of years, in time the benefit of DYI with a small % of holdings in addition to a large majority of Vanguard index funds can help wring out enough performance to make one happy. about the effort Your not sticking it to the man but you are informed and engaged, and therefore nimble. You cannot stick it to the whales as mentioned in the articles but if you know a few companies very well you can make some decent decisions at times. It also helps to be able to cost average down on those companies when needed. The key is to keep it to only a few select companies at any given time and give them and your hard earned money their due attention. Years not months.