Charmed by colorful trading apps, a pandemic that has left many stuck at home, and a growing list of popular companies to invest in: day trading and individual investing are on the rise. Trading activity among individuals started to build late last year when Charles Schwab and other top brokerage firms cut stock-trading commissions to zero. Now, starting with our recent market downturn in February and March of 2020, day trading is reaching new trading volume highs.
The first online brokerage firm is widely considered to be E*Trade Financial Corporation, started back in 1992. In the 1990s, online brokerages like E*Trade were the hot new way to "play" the stock market. Now there are a growing number of trading platforms available on your smartphone devices. Platforms such as Robinhood, Acorns, and Betterment allow the individual investor access to a large variety of stocks and funds. However, some worry that today's smartphone trading applications present too much risk, lack proper educational tools, and make trading too easy for retail investors.
Is day trading too easy?
The stock market has turned into somewhat of a game for young investors. "Gamification" has become a popular technique used by many of today's top trading platforms. By definition, to "gamify" something would be to apply typical elements of game playing to an activity, usually as an online marketing technique to encourage engagement with a product or service. Many feel today's gameplay features incentivize investors to make quick and uninformed decisions.
According to Robinhood, it has 13 million users and a median age of just 31. As you deposit funds with Robinhood you will immediately notice a confetti-like celebration on the screen of your smartphone. Then, confirming a purchase on the Robinhood phone application requires the user to swipe up, similar to the way many of its 31-year-old users use today's dating applications. Knowledgeable software industry experts state the gamification of these platforms create patterns referred to as "dark patterns" - a user interface designed to help consumers make less informed decisions.
Are individual investors making informed decisions?
Financial education is an integral part of ensuring all parties have a detailed understanding of not only the risks involved in investing but also the potential downsides associated with investing. An informed investor should be aware of their potential tax liabilities, investment diversification, costs, and taxability of their respective accounts. At DWM, this is perhaps the most important part of our job, educating our clients.
As many enter the stock market for the first time during 2020, some are seemingly unaware of the tax effects of their transactions. Robinhood, for example, cannot conduct trades in pre-tax accounts such as Individual Retirement Accounts (IRAs). Robinhood and others also offer very little in the way of educational planning on potential tax liabilities. So for those who have timed their investments at the end of March 2020 and sold at a high, they may be in for a surprise bill come tax season next year. Year-end tax planning should be at the top of any novice investors’ mind for the end of 2020.
Do individual investors understand their risks?
Given his experience in trading and portfolio management over the past few decades, I posed this question to our DWM Co-Founder and Head Portfolio Manager, Brett M. Detterbeck, CFA, CFP®, AIF®:
“In the wake of the 2020 pandemic, there have been handful of absolute winners such as Apple, Amazon, Netflix, Microsoft, Zoom, and Peloton that were made for this social distancing environment. Those names should undoubtedly be rewarded and the outperformance over companies that weren’t ready for this environment like those in the leisure/entertainment is valid, but to what extent?!? Day traders are jumping on the band wagon of these winners and pushing the valuation gap even wider. This is a cause for concern as valuation is a cornerstone of LONG-TERM investing and right now, valuation is all over the place. There’s never been more dispersion in the stock market than now with mega-cap growth names outperforming smaller cap value names. At some point, there will be a rotation. Will these newfound day traders be ready for that?
Moreover, in some instances, such as at Robinhood, investors receive a free share of an individual holding when they open an account. Experts suggest that by incentivizing individual holdings through freebies, investors are more likely to lack diversification and increase their risk exposure through company-specific risk – the risk that is usually unsystematic and diversifiable. Diversification is a proven way to mitigate risk in one’s portfolio and shouldn’t be overlooked. By loading up with only a handful of names, you are subject to torpedo risk, i.e. your portfolio going down like a torpedo when one of those handful of stocks implodes.
Further, many of these day traders have not done any due diligence/research on a company’s fundamentals. Instead, they buy a name purely based on its recent stock market ascent and/or the recommendation of some so-called expert on an online day-trader forum. This is not investing – this is speculation! And speculation is another name for gambling. Frankly, this is very reminiscent of the late 90s, where a lot of people were attracted by the booming returns of internet/tech companies and started trading stocks on their own. Unfortunately, we remember how the dot.com era ended, in a total bust with many of those day traders losing everything they had gained and then some. I’m deeply concerned for many of these newfound day traders that haven’t had the experience of a full market cycle. Will they know how to react appropriately? It’s easy to invest when the market is moving in one direction. But what happens when it doesn’t? What happens when optimism and elation give way to nervousness and fear?
Recall that people struggle to separate their emotions from their investment decisions. See the slide above which shows how emotions relate to the different stages of the market. These emotions cause these investors to sell and buy at the worst times as this "recency bias" influences undisciplined investors to chase performance through buying high and selling low.”
In conclusion, at DWM, we love crafting and managing well-diversified INVESTMENT portfolios. Even though this kind of investing may be construed as slow and/or boring; in the long-run, it is superior to speculating which we see as a glorified form of gambling. Enough about the latest fad and trying to hit the home run. Let’s focus on the things we can control. There’s so much noise out there and most of it is immaterial. We’re here to filter out that noise for people and help them win a slow, steady and most importantly successful race. We can do that by making their money work harder by eliminating the unforeseen landmines hiding within their portfolios and financial plans. We are encouraged by the growing interest in investing as a whole, however newer investors need to be aware that it’s not all confetti and glitter and a quick swipe.