More people are investing using trading apps. There are reasons to worry. : The Indicator from Planet Money Stock-picking retail traders have been jumping into the market this year. They may not understand the risks.
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Your Brain On Retail Trading

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Your Brain On Retail Trading

Your Brain On Retail Trading

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UNIDENTIFIED PERSON, BYLINE: NPR.

(SOUNDBITE OF DROP ELECTRIC SONG, "WAKING UP TO THE FIRE")

CARDIFF GARCIA, HOST:

Hey, everyone. Stacey and Cardiff here. This is THE INDICATOR FROM PLANET MONEY.

Buying and selling stocks on the smartphone app Robinhood has become incredibly popular this year, especially since the COVID pandemic started. And there are a few possible reasons why.

STACEY VANEK SMITH, HOST:

First of all, everybody is home and has lots of spare time. That's got to be part of it.

(LAUGHTER)

GARCIA: Maybe.

VANEK SMITH: Also, of course, you know, maybe people had a little extra money to invest because so many restaurants and shops were closed. Also, maybe people sensed an opportunity to buy stocks cheap when the stock market collapsed in the first month of the pandemic. Whatever the reason, Robinhood announced recently that the amount of money it makes from people trading on its app doubled in the second quarter of the year to $180 million. That's a lot of trades.

GARCIA: Yeah, and Robinhood has also become kind of famous for the clever ways that it entices people to use its app to buy and sell stocks. So digital confetti or some other animation might fall across the screen when you first deposit money into the app.

VANEK SMITH: We are simple creatures (laughter).

GARCIA: Yeah (laughter).

VANEK SMITH: That is my takeaway from that.

GARCIA: Not hard to get us in there, yeah.

VANEK SMITH: (Laughter).

GARCIA: And Robinhood also offers free stocks to people who sign up for a trial run and to people who convince others to sign up.

VANEK SMITH: James McComb (ph) is 25, lives in Long Island in New York. He is a big Robinhood user. And there are several things he likes about Robinhood's design and how simple and seamless it is to keep track of what's happening for any company he is interested in.

JAMES MCCOMB: It's a great app for easy information, almost like a news feed but for stocks.

VANEK SMITH: Plus, the Robinhood app shows a ranking of the most popular stocks that other Robinhood traders have been buying, which, you know, might convince new traders to join the party. James himself invested money in Uber stock partly because it was No. 1 on Robinhood's popularity ranking.

MCCOMB: I can kind of get a little bit of a sense of confidence, like, OK, people believe in this company because it's literally No. 1 on the list currently.

GARCIA: James is what is known as a retail trader, which is basically anyone who buys and sells stocks for their own personal account, not a professional investor who manages other people's money. And this year, it is retail traders like James who have really thrown themselves into the stock market.

VANEK SMITH: And because the U.S. stock market has gone up in recent months, even hitting a new record high last week, a lot of these retail traders have made quite a bit of money lately. But are there maybe some reasons to worry that so many retail traders have started buying and selling stocks using apps like Robinhood?

COLIN CAMERER: I would say two parts worried, one part happy.

VANEK SMITH: This is Colin Camerer. He's a behavioral economist at Caltech, and he has studied the ways that people invest in the stock market.

GARCIA: Colin says one good thing about Robinhood is that by making it so easy to start buying stocks, it might get people invested in the stock market who otherwise might never have bothered at all. And this can also help people learn more about how specific companies operate and to better understand how the economy works, especially these days - the digital age - when it's so easy to find useful information.

CAMERER: You know, there's a lot of stuff under the hood in the economy, and it would be good if people knew more about that. And they may learn some by just buying and selling some shares of a particular stock and learning about what boards of directors do and, you know, how companies actually operate.

GARCIA: But Colin said he was only one part happy and two parts worried about Robinhood's popularity with retail traders. So here's why he's worried. If there is one conclusion that the research about financial markets keeps arriving at again and again, it's that individual traders who actively try to pick specific stocks - buying the stocks they think will go up, selling the stocks they think will go down - are very likely to underperform the overall stock market.

VANEK SMITH: And this does not just apply to retail traders. It also applies to professional money managers. Over the last five years, 82% of mutual funds that tried to pick stocks underperformed the overall stock market, which means that most people are just better off investing in what they call an index fund that just tracks the performance of the stock market, goes up and down with it over time.

GARCIA: And Colin says retail traders are also vulnerable to psychological biases that lead them to make bad decisions when they invest, especially if they don't understand the risks that they're taking.

CAMERER: If you're buying, somebody is selling. And you have to be confident that you're buying from someone who knows less than you about the future of the stock. So one of the elements in retail trading is overconfidence. You know, everybody thinks they're above average.

VANEK SMITH: Also, confetti.

GARCIA: (Laughter) And confetti just sucks you right in.

VANEK SMITH: (Laughter).

GARCIA: Plus, people fall victim to what's known as the disposition effect, which makes people sell stocks that have gone up a little too soon, missing out on making even more money.

CAMERER: People have a tendency to sell the stocks that went up. And we think it's because there's a special kind of value called realization utility from actually locking in your gain and clicking and, like, seeing it in your bank account; you know, from your portfolio numbers on a screen into your bank account or something liquid. So people sell winners too soon. And similarly, they tend to hang on to losers, typically in a kind of blind faith that it's going to bounce back.

VANEK SMITH: Making these kinds of trading mistakes is something that happens when people are actively and frequently buying and selling stocks. And of course, the Robinhood app is designed to get people to do just that. And Robinhood's business model actually depends on it. More on this after a quick break.

(SOUNDBITE OF DROP ELECTRIC SONG, "WAKING UP TO THE FIRE")

VANEK SMITH: OK, so here is how Robinhood makes money. Let's say I have 10 shares of, like, Jamba Juice, and I want to sell them. I would place an order in the Robinhood app. Robinhood would then send that order to another company - a company called a market maker. That market maker would buy those 10 shares of Jamba Juice stock that I'm selling, and then it would try to sell those shares to someone else for more money than they paid me. And then it would keep the difference.

GARCIA: Yeah, the market maker is kind of like a bookie.

VANEK SMITH: (Laughter).

GARCIA: It just tries to match people who are buying with people who are selling, and it keeps the difference. And in exchange for the privilege of receiving those orders, the market maker pays Robinhood a fee. And the more orders it receives, the more it pays to Robinhood.

VANEK SMITH: So you can see why Robinhood has a big financial incentive to get people to buy and sell stocks frequently and why it's designed its app to encourage that outcome, confetti and all, even though that is probably not the best strategy for people to make money over time.

GARCIA: And this is why behavioral economist Colin Camerer says that people should not have more than about 10% of their overall money devoted to picking stocks on Robinhood and other apps like it.

CAMERER: It's a bit like gambling. So casinos know that there are people who have a problem with pathological gambling. And every casino, if you go to Las Vegas and you sit and have a free drink or you sit at the bar, will have a matchbook that says, have a problem gambling? Call this hotline. But they're not really in the business of keeping people from losing money. They're in the opposite business.

VANEK SMITH: Not to mention all of the lights and sirens and sound effects and free drinks.

GARCIA: And real-life confetti.

VANEK SMITH: Real-life confetti, that's true. James McComb, our Robinhooder (ph) from Long Island, says that he totally gets this. When he first started trading on Robinhood four years ago, he lost 80% of the money that he had invested in just a few months. Over the past year, though, he says he has almost made all of it back. Now he is just down 3%. But it's still a loss.

GARCIA: Yeah, a small loss, and he says he's cool with that. But you know what? Over the same four years, the overall stock market actually went up more than 60%.

VANEK SMITH: So he would've made more money if he had just invested in an index fund.

GARCIA: Yeah, a lot more money - and in fact, James actually says that he is much more careful with the money that he puts towards retirement. He invests that money in safer diversified funds.

MCCOMB: I haven't ever withdrawaled (ph) any money from Robinhood, so I don't actually know what the end goal for that money is. It's just something that I keep in there. And I - you know, maybe it'll end up being a bonus to my retirement. But I just don't - I don't see it as that. So I'm not, like, relying on that for my future.

(SOUNDBITE OF DROP ELECTRIC SONG, "WAKING UP TO THE FIRE")

VANEK SMITH: I know exactly what the goal of that money is.

GARCIA: What's that?

VANEK SMITH: It's confetti, right?

GARCIA: (Laughter) To buy confetti.

VANEK SMITH: It's confetti.

GARCIA: To buy confetti, like, real-life confetti. Throw a huge party.

VANEK SMITH: You're buying a little moment of joy, buying a little moment of joy.

GARCIA: A Robinhood spokesperson sent us a comment saying that Robinhood has invested in resources to help customers learn about the markets and make informed decisions and that the app is designed for customers to learn and to invest responsibly.

This episode of THE INDICATOR was produced by Jamila Huxtable and Nick Fountain. It was fact-checked by Brittany Cronin. THE INDICATOR is edited by Paddy Hirsch, and it is a production of NPR.

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