TERRY ODEAN HAS been studying investor behavior for decades. The University of California at Berkeley finance professor has proven again and again that everyday investors often harm their performance by trading too much.
Last year, Odean and his fellow researchers turned their attention to the Robinhood phenomenon. Result? When I spoke to Odean, he said the only thing that surprised him was the magnitude of the self-inflicted investment wounds by users of the free-and-easy trading app. Many of the app’s users are first-time investors buying and selling not just stocks, but also options.
Odean and his co-authors studied trading activity over a two-year period through August 2020, analyzing stocks experiencing so-called herding events, where investors crowd into particular investments, often buying simply because others are doing so. The authors defined those herding events using measures such as percent gain and level of ownership by Robinhood users.
“We concluded that, over a 30-day period starting 10 days before the [herding] event and ending 20 days after, the Robinhood community that invested in these herding stocks lost on average about five percentage points.” That loss increased to six percentage points if you look at investors’ returns relative to the market’s performance.
Odean’s Robinhood study predates this year’s excitement over “meme stocks,” such as GameStop and AMC Entertainment, which involved similar herding behavior. Somehow, legions of novice investors allowed themselves to be persuaded—in part by Robinhood’s free trading platform, in part by internet chat rooms such as Reddit’s r/wallstreetbets—that trading stocks and options is fun and easy. (Recently, Robinhood discontinued its practice of showering users’ screens with confetti when they made a trade.)
But some investors went even further: They adopted the ethos that, by herding together into stocks touted by influencers such as Keith Gill (a.k.a. Roaring Kitty, a.k.a. DeepFuckingValue), they were “sticking it to the man” by squeezing hedge funds that had “shorted” stocks in a bet that those stocks would fall in value. The very name Robinhood suggests taking money from Wall Street’s modern-day Sheriffs of Nottingham. And the herd did, indeed, badly trample hedge fund Melvin Capital, which reportedly lost $53 million in January betting against stocks that Robinhood users piled into.
But Odean’s study shows that, as a group, other investors—presumably professional money managers—routinely and profitably bet against the Robinhood investors. “There are traders out there who are intentionally shorting the stocks that have these (herding) events,” Odean said.
Robinhood may not be charging commissions for trading, but that doesn’t mean the trading app doesn’t make money. “Robinhood’s not doing it for free,” Odean noted. “They’re just getting paid by someone else.”
That someone else are Wall Street’s market makers, who make money off the so-called bid-ask spread, the higher price at which investors can currently buy a stock and the lower price at which they can sell. To handle more trades, these market makers engage in “payment for order flow”—and these payments are what enable Robinhood to offer commission-free trades to investors.
The order flow from Robinhood seems to be particularly attractive to Wall Street’s market makers. According to an SEC regulatory filing last year, Wall Street pays much more per share for Robinhood order flow than it does for that of Schwab and E*Trade. Customers at these other firms have average balances higher than the reported $2,000 at Robinhood, tend to be more experienced and trade much less frequently.
What’s the downside of all this? One way that Robinhood investors lose—or, at least, have in the past—is through poor trade execution. The company paid a $65 million fine to the SEC in December for “failing to satisfy its duty to seek the best reasonably available terms to execute customer orders,” the agency said in announcing the fine.
“Robinhood falsely claimed in a website FAQ between October 2018 and June 2019 that its execution quality matched or beat that of its competitors,” the SEC said. “The order finds that Robinhood provided inferior trade prices that in aggregate deprived customers of $34.1 million even after taking into account the savings from not paying a commission.”
The implication: Robinhood is “giving their clients worse execution,” Odean said. “You don’t have to charge them a commission because (Wall Street market makers are) getting the opportunity to trade with uninformed investors and give them a lousy deal.”
If you got into GameStop early, congratulations. Maybe you’ve been able to pay off your student loans. If you didn’t get in early, you could have experienced a loss of up to 88% in a matter of weeks. As of yesterday, GameStop was trading at about $143 per share, 59% below its Jan. 27 high of nearly $348.
“A lot of these Robinhood investors are probably not risking money that they can’t afford to lose,” Odean said. “But some of them are, and those are the ones that worry me.”
William Ehart is a journalist in the Washington, D.C., area. In his spare time, he enjoys writing for beginning and intermediate investors on why they should invest and how simple it can be, despite all the financial noise. Follow Bill on Twitter @BillEhart and check out his earlier articles.