New research shows that the surge of market participation through the Robinhood platform has been driven by young, uninformed users who lack the skill to generate “alpha,” resulting in increased noise and volatility for all investors.
The arrival of investing platforms with zero trading commissions and no account minimums has ushered in a new era of stock market participation. For example, Robinhood reported three million new accounts in the first quarter of 2020 alone.
Gregory Eaton, T. Clifton Green, Brian Roseman and Yanbin Wu, authors of the January 2020 study, “Zero-Commission Individual Investors, High Frequency Traders, and Stock Market Quality,” examined data from Robinhood to explore the financial market implications of commission-free individual investors. They began by noting that retail investors now account for about 20% of daily trading. Their data sample covered the period July 2018 through August 2020 and more than four million trades. Before reviewing their findings, it’s worth noting that the three most popular Robinhood FAQs, an indication of the level of financial literacy, are: “What is the stock market?” “What is the DJIA?” and “What is the S&P 500?”
Following is a summary of their findings:
- Investors drawn to zero commissions and user-friendly trading platforms tend to be younger (average age 31) and less wealthy (average account balance between $1,000 and $5,000) than retail investors of the 1990s (average age 50 and average balance of almost $50,000, not adjusted for inflation).
- Robinhood users tend to invest in volatile stocks and equities with more high-frequency trading.
- Robinhood investors trade after other retail traders.
- There is no evidence that changes in Robinhood ownership predict future returns – Robinhood traders are “noise” traders, not informed traders.
The authors also analyzed the effects of zero-commission investors on market quality by isolating and examining the periods when Robinhood experienced outages. They found:
- Stocks favored by Robinhood investors experience significantly lower trading intensity and volume (about 6% less) during platform outages.
- Robinhood platform outages are associated with improved market quality (lower bid-offer spreads and less market impact) among stocks favored by Robinhood investors. Outages are associated with price impacts that are 5.1 basis points lower, relative to a mean of 61 basis points – the presence of zero-commission investors is deleterious to market liquidity.
- Robinhood outages are associated with lower return volatility – zero-commission traders contribute to volatility, consistent with noise trading models.
- Robinhood outages coincide with reduced market activity by high frequency traders (HFTs), consistent with negative shocks to Robinhood trading reflecting negative information flow shocks to HFTs.
- The positive effects of Robinhood outages on market quality are strongest for stocks with little involvement by HFTs, providing convincing evidence that the market effects of outages are driven by zero-commission traders rather than predatory HFTs.
Their research led Eaton, Green, Roseman and Wu to conclude: “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.” Consistent with their finding that Robinhood investors are uninformed, they also cited prior research findings that “younger investors are less financially literate and more prone to mistakes.” Their finding that Robinhood investors are, in aggregate, uninformed noise traders is consistent with that of the 2020 study, “Attention Induced Trading and Returns: Evidence from Robinhood Users,” which found that attention-induced herding by Robinhood investors is accompanied by large price movements and subsequent reversals. Eaton, Green, Roseman and Wu also concluded: “Robinhood investors may negatively impact market quality.” This result is likely due to the herding behavior of Robinhood investors, which increases inventory risks to market makers.
Summary
Robinhood, with commission-free trading, has certainly been successful in its stated mission, having attracted 13 million users with its app that makes trading easy. Unfortunately, its application also leaves naive individual investors more susceptible to well-documented biases that lead to speculative trading and poor results, with the winner being Robinhood itself.
The historical evidence of efforts by individual investors to generate alpha clearly show that while it’s not impossible to generate alpha on a consistent basis, the odds of doing so are so poor it’s not prudent to try. In other words, if you look in the mirror and see Warren Buffett, go ahead and try to pick stocks that will outperform. But unless you live in Lake Wobegon, where everyone has Buffett-like abilities, you’re not likely to see the Oracle of Omaha in the mirror. For those who don’t, the winning strategy is to build a globally diversified portfolio that reflects your unique ability, willingness and need to take risk, and stay the course, rebalancing and tax managing as events dictate.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
Important Disclosure: The information contained in this article is for educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. The analysis contained in this article is based upon third party information available at the time which may become outdated or otherwise superseded at any time without notice. Certain third-party information is based upon is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth®, Buckingham Strategic Partners® (collectively Buckingham Wealth Partners). LSR-21-25
Read more articles by Larry Swedroe
New research shows that the surge of market participation through the Robinhood platform has been driven by young, uninformed users who lack the skill to generate “alpha,” resulting in increased noise and volatility for all investors.
