Investing for everyone? Not without risks and side effects

Everyone these days has access to securities-trading platforms and financial market information. Ultra-low fees, innovations such as fractional shares, and the internet and social media make this access possible. Public interest in the topic of investing surged once again in the year of the coronavirus. But the “democratization of investing” is not without risks and side effects. And professional, personalized investment advice will continue to provide (added) value in the future.

 

Using coronavirus stimulus checks to speculate on stocks

Once upon a time, securities trading was considered the reserved domain of a well-heeled and/or financial-market-savvy clientele. You had to have a certain amount of money in your investment account, brokerage commissions and fees were high, and whoever wasn’t occupationally involved with financial markets sometimes had to work hard to acquire financial acumen. But those days are long gone. The barriers that formerly existed are much lower nowadays or have even completely vanished.

Whoever would like to trade stocks these days can do it online with just a few clicks on his or her smartphone and with the tiniest of budgets – thanks to Robinhood. This US-based online broker founded in 2013 – or better said, its app – has rapidly turned the brokerage industry on its head. Robinhood’s concept: Everyone should actively participate in the financial markets regardless of the size of his or her wallet. Robinhood’s solution: Making stock trading free of charge. The startup’s enormous success, as measured by its soaring number of customers, left established competitors no other choice but to follow suit sooner or later. Since 2019, investors in the USA can now also trade for free with TD Ameritrade, E*Trade, Charles Schwab and Interactive Brokers. Even the high price of a stock is no longer a hindrance. The advent of fractional shares now enables an investor to purchase, for example, as little as one-twentieth or less of an “expensive” share of Amazon, which currently costs more than 3,000 US dollars. Even someone who has only 10 dollars to invest can get in on the action.

The “democratization of investing” has been a much-talked-about meme lately. It reached a new level last year, more or less as a side effect of the coronavirus pandemic. Because apart from inflicting personal tragedy on many people, the pandemic also gave them more time at home to spend in front of their computer screens (or on their smartphones) in a state of boredom and with a coronavirus stimulus check from the government in hand. This “gambling money” ended up in many investment accounts, sometimes simply because alternatives such as sports betting were in scarce supply due to the pandemic. Private investors in the USA alone opened more than 10 million new investment accounts in 2020, and the inflow of new investors continues to this day. The Robinhood app, for example, was downloaded another 500,000 times in December alone. The heightened public interest in investing is a worldwide phenomenon that is also observable in Europe and Asia, and it’s being spurred not least by the trajectory of the stock market, which has been heading upward almost uninterruptedly since the coronavirus crash in February and March of last year.

 

Bullish bets predominate

Hedging is not in demand at present

Volume of call and put options on US exchanges, in millions of contracts

Sources: Bloomberg, Kaiser Partner Privatbank

 

The Robinhood effect

That more and more (small) investors are playing the stock market is a fact measurable in hard numbers. According to data from Citadel Securities, private investors accounted for 20% of all equity-market transactions (and for a whopping 25% on peak days) in the USA last year, twice as many as in 2019. In addition, more and more investors have long since gone beyond trading ordinary stocks. They are also increasingly betting on (call) options to parlay a smaller investment of (leveraged) capital into even bigger profits. US private investors now account for more than 55% of the contract volume on the options market (compared to 40% prior to the pandemic).

All of this is not without consequences. Although the trading activity of this new generation of investors has not (yet) had a measurable impact on big Wall Street stocks such as Apple, Microsoft and the like, the picture looks different in the small- and micro-cap segment, which has routinely seen erratic share-price movements in recent weeks and months. There’s a fitting term for the numerous examples: the Robinhood effect. The stock price of car rental company Hertz, for instance, shot up several hundred percent in the span of a few days in May of last year even though Hertz had previously filed for Chapter 11 bankruptcy. The cheap share price of less than one US dollar probably looked too alluring to many novice investors. Another anecdote recounts the case of the penny stock Signal Advance, a company so small that it isn’t even required to file financial statements with the US Securities Exchange Commission. After Tesla CEO Elon Musk tweeted “use Signal […instead of WhatsApp…],” Signal Advance’s stock price rocketed from 60 cents to almost USD 40 in the space of a few days before plummeting just as quickly. Musk wasn’t actually referring to the one-man company in Texas; he meant the messaging app Signal from the Signal Foundation.

 

The cheaper, the better

Stocks with a small price tag perform better

Performance of stocks in the Russell 3000 index by price bracket

Sources: Bloomberg, Kaiser Partner Privatbank

 

The lower a stock’s trading volume is, the greater the influence of retail investors. At the same time, newsfeeds and social networks often lay the foundation for leaps and crashes in stock prices. Twitter, Discord, TikTok, Reddit, Instagram and Facebook rank among the best-known forums for hot stock tips. The ones that circulate there regularly turn into self-fulfilling prophecies when a (sharply) rising share price of a company incites further buying that drives the stock price even higher.

Another example seen in recent days illustrates the kind of momentum that Robinhood traders can unleash. The business fortunes of GameStop, the USA’s largest video game retail chain, had been on the decline for years – the company completely missed the trend toward online gaming. Its stock price was accordingly low; it was languishing at around USD 4 per share in summer of last year. But it spiked to USD 20 by Christmas. The real financial suspense story, however, has been playing out since the start of this year. While hedge funds deliberately bet on a falling stock price in view of GameStop’s poor fundamentals, in recent weeks private investors on the Reddit forum WallStreetBets discussed ways to trip up the masters of Wall Street and initiated a gigantic short squeeze. Interest in GameStop steadily increased. Then on January 25, trading volume in GameStop stock exceeded the company’s number of shares outstanding by 2.5 times. On that day, GameStop’s stock price intermittently climbed to USD 160 in intraday trading before plunging 50% in the space of a few minutes. But even that wasn’t the end of the story yet. Afterwards the stock price reascended to an even higher level – that rally has lifted it to an interim peak of almost USD 400 at last look.

The identity of one of the victims of this latest Robinhood episode is already known: the hedge fund Melvin Capital, which recently had bet that the share prices of GameStop and other companies would fall, suffered a double-digit percent loss in the first week of January. A USD 2.75 billion cash injection from hedge fund colleagues at Citadel and Point72 Asset Management kept the damage from worsening.

 

What goes up…

…must (eventually) come down

GameStop share price

Sources: Bloomberg, Kaiser Partner Privatbank

 

The risks and side effects

This story is indeed somewhat reminiscent of the legend of Robin Hood – money was taken from rich hedge fund managers and given to (comparatively) poor retail investors. But then again, the story isn’t all that fairytale-like. Whoever jumped late on the bandwagon could just as easily have ended up on the loser’s side, where he would have watched his investment shrink in half at fast-forward speed. Of course, this can happen not just with shares of companies with poor financials or dubious business models. All it takes is a tweet from Elon Musk, for example, who said this week that he likes Etsy. The stock price of the online marketplace for handcrafted and vintage products afterwards jumped by more than 10 US dollars in pre-market trading, only to end the day 10% below its intraday high. This is another example illustrating that the brave new investor world also holds risks in store unbeknown to many financial-market novices, particularly since apps like Robinhood make investing seem like a game. Whoever opens an investment account or refers a friend to open one gets free stocks. And bursts of colorful confetti celebrate executed transactions. Whoever purchases a premium membership for five dollars a month becomes a Gold customer and can even speculate on credit.

The brave new investor world also holds risks in store unbeknown to many financial-market novices.

Where the gamification of investing and the lack of clear explanations of the risks involved can ultimately lead in the worst case was poignantly brought to light by an incident in summer 2020 that made big waves in the media. A 20-year-old Robinhood trader committed suicide after reportedly seeing that he had a negative balance of more than USD 730,000 on the app. Afterwards it turned out that his account was never in deficit at any time – he just was unable to fully comprehend the complex options instruments he was trading. This incident hasn’t been the only stain on Robinhood’s record. In December, the US Securities Exchange Commission (SEC) slapped a severe USD 65 million fine on the broker for not having disclosed to its customers that it makes its money by reselling users’ securities orders to high-frequency traders. This “payment for order flow” business generated Robinhood more than USD 270 million in revenue in the first half of 2020 alone. Customers, on the other hand, get the short end of the stick. The SEC came to the determination that they would have gotten much better execution prices if they had traded via rival brokers and paid the usual commissions instead of trading purportedly commission-free on Robinhood.

 

Leveraged speculation

Low interest rates are all too tempting

Margin debt volume in the USA, in USD billion

Sources: FINRA, Kaiser Partner Privatbank

 

The added value of professional investment advice

But even though this wave of democratization of investing has its drawbacks, increased public interest in the financial markets fundamentally is a very positive development, because not every new investor intends to gamble on the stock market. The majority of new investors are devoting serious thought to investing for the long term and planning for retirement. More and more members of this young investor generation also want to gain an understanding of how their investment decisions affect our environment and society. Many of them know full well that a game-like app and commission-free trading alone don’t offer much help on these matters. More and more investors are discovering the value of receiving prudent, comprehensive, personalized investment advice.

An analysis performed by Cerulli Associates last October revealed that 40% of US investors say they need more investment advice, and 56% of the survey respondents are willing to pay something for it. And 82% of those who already do pay for investment advice say they are satisfied with it. Other research conducted by Franklin Templeton and Gallup shows that investors who consult with financial advisors feel they have chosen the right investment strategy more than twice as often as do-it-yourself investors.

Each individual client’s personal circumstances, goals and needs have always stood at the center of the investment process at Kaiser Partner Privatbank. Using innovative, sustainable investment solutions and in close dialogue with clients, we will continue in the future to pursue the goal of earning above-average risk-adjusted returns.

 

Oliver Hackel, CFA Macro and Investment Strategy, Behavioral Finance and Technical Analysis

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