- Day trading has become a popular pastime,
being stuck at home
during the pandemic probably played a role
but the explosion in price
from a handful of so-called meme stocks
is what got everyone's attention,
it was like a modern day gold rush.
In Canada, we even have our own mobile first
commission-free trading platform,
making this pastime accessible
to anyone with a smartphone and a few extra dollars.
I made a video about day trading last year,
I'll summarize my thoughts from that video in a minute.
A lot of the feedback that I got when that video came out
is that the papers I was relying on
were too old to be relevant
in the modern age of free trading
and seamless access to information.
It's true.
Many of my sources in that video
predated the free trading and smartphone revolutions.
I'm Ben Felix, Portfolio Manager at PWL Capital.
In this episode of Common Sense Investing,
I'm going to tell you
how technology has changed day trading.
Last time I talked about day trading,
I concluded, based on sixth published academic papers,
that day trading is not a profitable activity
for the vast majority of people.
And that more frequent trading
leads to a higher likelihood of poor performance.
I also pointed out that individual investors
tend to focus their trades on attention-grabbing stocks
instead of rationally assessing
the full global opportunity set
which increases the likelihood of trailing the market
given the skewness in stock returns.
Those papers, or the data on which they were based,
were from a time before many of today's innovations.
Watching stocks like GameStop and AMC go to the moon,
made it seem like there was a lot of money to be made
in joining the online herd of like-minded investors.
Fortunately, academic research has begun
to investigate the effects of platforms like Robinhood
that make trading more accessible to more people.
Brad Barber and Terrance Odean have authored a huge portion
of the research on individual investor behavior.
Their research is showing
that individual investors underperform,
sell winners and hold losers
are influenced heavily by attention-grabbing stocks
and recent past performance,
and they hold undiversified stock portfolios.
In a 2020 paper, Attention-Induced Trading and Returns
Evidence from Robinhood Users,
Barber, Odean, and two co-authors
examined the Robin track data series
pulled from Robinhood's API.
These data allow researchers to view anonymized data
for Robinhood users
and analyze their behavior and performance.
The researchers suggest that attention-influenced investors
are more likely to exhibit herding behavior.
As suspected, they find that 35% of Robinhood users
net buying activity is concentrated in only 10 stocks
compared to 24% for the general population
of retail investors.
They also find multiple herding episodes per day,
where the number of Robinhood users
owning a particular stock increases dramatically,
and that herding behavior is predicted
by measures for attention,
like recent investor interest,
recent extreme returns, or unusual trading volume.
Finally, they find that during Robinhood outages,
retail trading drops more in high attention stocks.
Chasing attention-grabbing stocks is nothing new
for retail investors,
it was documented by Barber and Odean in 2007.
The effect of attention on buying behavior
was documented as being more prevalent among new investors
by Seashols and Woo in 2007,
this is relevant considering the influx
of new investors attracted by free trades,
fractional shares, and meme stocks.
In their S-1,
Robinhood explains that nearly half
of their 18 million customers were first-time investors.
One of the things influencing the attention
of Robinhood investors may be the trading interface itself
which shows the stocks of the day
with the biggest price changes.
Barber and Odean find support in the data
for the idea that Robinhood's app design
is impacting the trading decisions of its users.
If the concentrated buying and selling that stems
from attention-driven investors
resulted in great returns,
as the internet may have you believe,
then this would be good news for retail investors
but this study finds that the top 0.5%
of stocks bought on Robinhood every day
lose about 4.7% on average over the subsequent month.
This doesn't necessarily mean
that Robinhood users are taking losses on these trades,
they may be riding the herd up
and getting out before the decline.
The study authors looked at this too,
and found that the Robinhood community loses about 5%
during each herding event or 6% adjusted for market returns.
The finding suggests that extreme herding
causes negative wealth outcomes
for the overall Robinhood community.
The technological advantage
of investors being able to band together
through an easy-to-use app
seems like it's making profitable day trading harder
rather than easier due to the effects
of attention on buying and selling behavior.
The psychological impact of trading on a mobile app
may contribute to the challenge for investors.
A 2021 paper by Ankit, Kalda, and co-authors
titled "Smartphone Investing"
are within investor time analysis
of new technologies and trading behavior
uses data from two large German retail banks
that have introduced trading applications
for mobile devices.
The data are for over 18,000 bank clients
and it allows researchers to observe
whether trades were placed on a PC or on a smartphone.
The study authors find
that the probability of purchasing assets
with higher volatility and more positive skewness,
in other words, lottery-like stocks
with high probabilities of poor payoffs
and low probabilities of great payoffs,
increases in smartphone trades
compared to non-smartphone trades.
Specifically, they find a 67% increase in the probability
of buying lottery-type stocks for smartphone users.
They also find that smartphone traders
hold more non-diversifying assets, like individual stocks,
and they're more likely to buy attention-grabbing assets
like past winners and losers.
In the German sample,
the study authors find
that smartphone trades trail the market
by an average of 1% for the 12 months following the trade
while also having a lower average Sharpe ratio.
So far we've seen the effect of attention
on investor outcomes.
The social aspect of mobile trading
may be doing more harm than good
but I think there's probably more to the story here.
Everyone drinks more at an open bar.
The perception of free trades
may make people more inclined to trade more frequently,
and this has been observed with Robinhood users
who trade far more frequently
than users of other discount brokerages.
In the first quarter of 2020,
Robinhood users traded nine times as many shares
as E-Trade customers,
and 40 times as many shares as Charles Schwab customers
per dollar in the average customer account.
A classic paper in the Journal of Finance
by Barber and Odean,
titled "Trading is Hazardous to your Wealth.
The Common Stock Investment Performance
of Individual Investors,"
examines a data set of 66,465 households with accounts
at a large US discount broker between 1991 and 1996.
They find that individual investors
are overconfident based on the empirical evidence
that the average household earns a return
close to the market before costs
but trails the market by 1.1% annually after costs,
they trade to their own detriment
which is something that we would expect overconfident
but unskilled traders to do.
They find that the average household over this period
tilts its portfolio toward riskier, small cap value stocks.
Accounting for these additional risk exposures
using the Fama-French three-factor model,
the average household trailed a risk-appropriate benchmark
by 3.7% annually.
The average household in their sample
turned over about 75% of its portfolio holdings annually,
and the associated transaction costs
explain their poor performance.
The 20% of households in the sample
that traded the most often,
turning their holdings over more than twice annually
earn net returns that trail the market by 5.5% annually,
and trail a risk-appropriate benchmark by 10.3% annually.
A 2009 study titled "Sensation Seeking Overconfidence
and Trading Activity" finds in a data set from Finland
that investors who are most prone to thrill seeking
and those who are most overconfident trade the most.
All right, all right.
Now those were old papers,
things are different now.
There are no commissions
so turnover does not increase costs, right?
Commissions are only one component of trading costs.
The way that trades are executed
can also make a significant contribution.
In December, 2020,
the SEC charged Robinhood for misleading customers
about their revenue sources
and failing to satisfy their duty of best execution.
It was determined that between October, 2016 and June, 2019
for most orders of more than 100 shares,
Robinhood customers would be better off
trading at another broker-dealer
because the additional price improvement
that such orders would receive at other broker-dealers
would likely exceed the approximately $5
per order commission costs
that those broker-dealers were then charging.
For orders over 500 shares,
the average Robinhood customer order lost over $15
in price improvement compared to Robinhood's competitors.
With that comparative loss rising to more than $23 per order
for orders over 2000 shares.
Nothing is really free.
In Canada, we don't have payment for order flow
which was causing the issue
I was just describing for Robinhood,
but Wealthsimple Trade charges other fees
like a 1.5% currency conversion fee
if you wanna trade securities outside of Canada,
which anyone trading based on attention
is likely to want to do.
This should not surprise anyone,
both Robinhood and Wealthsimple are valuable companies,
which doesn't happen without a way to make profits
from their customers.
Trading always has a cost,
even if you don't see it explicitly in your account,
more trading increases costs
and decreases net of cost expected returns.
The last point that I wanna make
is related to market efficiency.
Does the development of app-based herding
break efficient markets?
No, it doesn't.
When Eugene Fama came up
with the efficient-market hypothesis,
all he was saying was
that prices reflect all available information.
The EMH does not make a judgment
on the information that is in prices,
the information may be rational assessments
by calculating investors,
it may be irrational, over or under-reaction
from biased investors,
or it may be related to a preference unrelated to risk
and expected returns for owning a specific stock.
For making investment decisions,
these differences in information origination
don't matter much.
Without making a judgment
on how the information got in there,
prices still contain information
that can be used to assess differences in expected returns.
Higher prices relative to business fundamentals
mean lower expected returns,
and lower prices mean higher expected returns.
Trying to outsmart market prices is a losing game.
Free trades have not made day trading any easier
to profit from,
if anything, free trading and the social nature
of meme stock culture have increased herding behavior,
preference for lottery-type stocks,
concentration in attention-grabbing stocks,
and frequency of transactions
for the individual investors on these platforms.
All of these things are detrimental to investor outcomes,
especially for those thrill-seeking
and overconfident investors who trade the most.
Finally, the herding behavior of app-based investors
is not breaking market efficiency.
Market efficiency means that prices reflect information,
it does not make a judgment
on whether prices reflect rational assessments
of risk and expected return, irrational or overreactions,
or preferences unrelated to risk and expected return.
And it doesn't matter, regardless of the information source,
most investors cannot outsmart market prices.
Thanks for watching.
I'm Ben Felix, Portfolio Manager at PWL Capital,
and this is Common Sense Investing.
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