How Robinhood’s Trading App Stimulates Investor Herd Instinct: Q&A with Professor Odean
Newswise – Last year, when Terrance Odean, professor of finance at Berkeley Haas, researched why users of the popular Robinhood trading app tended to ‘bundle’ into a small number of stocks, he never had imagined a situation like the one that unfolded last week with GameStop.
“It was like a breeding event supernova,” he said.
Shares of the dying video game retailer climbed more than 400% in three days when a crowd of investors, many of whom gathered on the Reddit WallStreetBets chat room, coordinated to buy the shares en masse. It fell 44% the next day, as Robinhood and other brokerage firms temporarily restrained GameStop’s new purchases. Although trading has resumed, the stock has been mostly down but remains volatile. Tens of billions of dollars in market value have been created and wiped out.
Odean had examined how Robinhood’s easy-to-use technology influenced investor behavior and stock prices. Menlo Park, founded in 2013, has achieved enormous success, especially among young investors. It was “the first brokerage to offer commission-free transactions on a convenient, simple and attractive mobile app,” Odean wrote in a work document he co-wrote with three other finance professors.
Make trading fun
The Robinhood app makes investing fun and—critics say-addictive. New members get a free share of the stock after scratching the image of a lottery ticket, and when they reach certain milestones, digital confetti is raining down on their screen. Robinhood users can start trading as soon as they open an account.
“Half of Robinhood’s users are first-time investors, who probably haven’t developed their own clear criteria for buying a stock,” the newspaper said. “The application prominently displays lists of actions in an environment relatively devoid of complex information. For example… Robinhood only provides five chart indicators, while TD Ameritrade provides 489. ”
The app draws attention to Robinhood’s 100 ‘Most Popular Stocks’ and a narrower list of ‘Most Popular Stocks’ which shows which 20 stocks, throughout the day, have the biggest changes. positive or negative percentage.
Using Robintrack, A database of the most popular stocks among Robinhood users from May 2018 to August 2020, the researchers compared its users’ trades to other retail investors. They also looked at trading “attention grabbing” stocks for three days when Robinhood system outages prevented its users from trading.
They concluded that the simplicity of Robinhood’s app, combined with its users’ inexperience, made them more likely to cluster or pile into a smaller set of stocks than other retail investors.
Short sellers took note
They also looked at what happened to a stock’s price when it was subjected to a herd event or an ‘extreme herd’ event, the latter being the days when the number of Robinhood users who own a share increased by 1,000 users and 50% compared to the previous day. . These stocks showed unusually large gains on the day of breeding, averaging 14% for a regular breeding event and 42% for an extreme breeding event. The next day, however, yields turned “significantly negative” and were still down – 5% and 9%, respectively – after 20 days.
“While some Robinhood users undoubtedly made money, in our analysis a greater number of them lost money,” said Odean.
The team also documented a “marked increase in short selling for stocks involved in Robinhood breeding events,” a sign that some investors have exploited these “predictable negative returns” by betting on the downfall of Robinhood favorites. The co-authors of the article are Brad Barber of UC Davis, Chris Schwarz of UC Irvine, and Xing Huang of Washington University in St. Louis.
We asked Odean about Robinhood, GameStop, and the lessons to be learned from recent events.
Q: Have you ever dreamed that there would be a breeding event like GameStop?
A: It would be nice to say that I saw it coming, but no. What we are seeing with Robinhood is a similar herd to what has been documented in other situations, but previously the magnitudes were much lower. We saw herds in the 1970s and 1980s, when people bought stocks mentioned on Monday Friday night during Louis Rukeyser’s Wall Street Week, a public television show. Now what you have are a lot more investors whose attention is directed to what is often a small set of illiquid stocks and who are buying at the same time.
What’s surprising about GameStop is the extent to which people were writing (mainly on the Reddit WallStreetBets chat room) about how we’re all going to be consciously doing the same thing at the same time and therefore possibly affecting the prices. of the market. This aspect of the GameStop fiasco is not in our article.
Is what you just described illegal?
I’m not a lawyer, but from what I understand if two hedge funds started emailing each other that if we both bought these stocks in large numbers on Tuesday it would drive the price up. – it would probably be illegal.
I don’t know what will happen with GameStop, but it is much harder to argue against millions of people who spend small amounts of money than against a small number of sophisticated investors who do so with big bucks.
I don’t know what will happen with GameStop, but it is much more difficult to argue against millions of people who spend small amounts of money than against a small number of sophisticated investors who do so with a lot of money.
Did Robinhood make investing too easy?
He changed the behavior of people by making it simple. Robinhood’s mission statement is to democratize investing for all. Jack Bogle (founder of Vanguard Group) did this years ago. You can buy a Vanguard Index Fund, pay $ 4 per year for every $ 10,000 you invest, and have a well-diversified long-term investment in the US market and economy. It is democratization. What Robinhood has done is facilitate trade.
How does Robinhood make money?
Put the fist back. They sell their clients’ orders to market makers. If you want to sell, market makers buy from you, and vice versa. When market makers take the other side of a trade, they face the risk of information asymmetry, the risk that they are trading with someone who knows more than them. Market makers seem to think that when they trade with someone from Robinhood, they are not taking that risk. They think if I always take the opposite side of Robinhood, I will make so much money that I can pay Robinhood.
This is called “order flow payment”, and it’s nothing new. Other retail brokerage firms do this as well.
(As of December 2020, the Securities and Exchange Commission accused Robinhood by failing to properly disclose its payments for the flow of orders to customers and failing to seek the best terms for their transactions. Robinhood paid $ 65 million to fix the changes without admitting or denying his guilt.)
Should regulators ban this practice?
It is complicated. Without payment for the order flow, there will be no trading without commission. My concern is that investors are only aware of the costs which are direct and explicit. Most investors are aware of the commissions, but not the payout for the order flow. If investors mistakenly believe that zero commission means free trade, they are likely to trade more actively and in a more speculative manner. I think we should get rid of the payment of order flow, but we have to be careful of the unintended consequences of well-intentioned regulations.
What is the most important lesson to take away from this GameStop event?
Retail investors whose transactions are highly correlated – through forums like WallStreetBets or other means – have more market power than many on Wall Street thought.
Retail investors whose transactions are highly correlated – through forums like WallStreetBets or other means – have more market power than many people on Wall Street expected.
Why has Robinhood temporarily halted new purchases on Gamestock, AMC and other stocks subject to extreme volatility?
Depository Trust and Clearing Corporation asked Robinhood to put in more capital to ensure that Robinhood would complete the trades it placed for its clients. Brokerages are required to use their own money as collateral while they wait for transactions to clear. Robinhood’s clearinghouse has increased its capital requirements due to the increase in orders on GameStop and other stocks and because those stocks have become extremely volatile. Robinhood reopened the business after raising $ 3.4 billion in additional capital.
Traders have reportedly targeted companies like GameStop because a large percentage of their stock has been sold short by hedge funds and others. This means that the short sellers borrowed GameStop shares and sold them, hoping to buy them back later at a lower price and pocket the difference. When GameStop shares soared, hedge funds suffered massive losses when they had to buy the shares at higher prices, which put even more upward pressure on GameStop shares. Some traders describe the short sellers as the “bad guys” and Robinhood traders as the “good guys.” Are there really good guys and bad guys here?
Financial economists believe that short selling plays a useful role in markets by allowing investors with negative information or opinions about a stock to influence prices and thus prevent prices from being set only by investors. optimistic. However, sometimes short sellers behave badly by promoting negative company rumors after establishing their short positions. I haven’t read that this is a major issue with GameStop. I would say people who intentionally manipulate stock prices are called bad guys. And Jack Bogle, who tried to make investing cheaper and safer, was a good guy.