Are trading apps propping up markets?

The rush of armchair traders investing through Robinhood, an easy-to-use app for trading stocks, may be helping inflate a stock bubble and setting up investors for a potential bust.

The ease of access to quick, fee-free trading has lured millions of inexperienced investors into a gamified trading environment and raised questions about both consumer protections and effects on the broader markets.

Goldman Sachs found that daily average trades had doubled in early 2020 as individual investors piled into the market. Robinhood, in particular, went from 4 million users invested in S&P 500 stocks before the pandemic to 12 million in May.

By some revenue measures, it has become the second largest trading platform behind TD Ameritrade, surpassing giants such as E-Trade, Charles Schwab and Fidelity.

“It’s interesting how fast it’s happened,” said Paul Rowady Jr., director of research at Alphacution Research Conservatory, which has compiled data pointing to the app’s monumental growth.

“Robinhood has devised this seamless, gamified app that makes it fun and easy to interact with, which is maybe more fun because you’re sitting at home. This is like a video game with real money,” he said.

The concern is twofold: that a rush of unsophisticated investors may be helping inflate stock prices beyond their true values, and that a crash will leave many of them worse off at a time when the economy is already on the skids.

“The thing that’s worrisome is that they’re piling into stock and pushing valuation up significantly,” said Gene Goldman, chief investment officer of Cetera Investment Management.

The May research note from Goldman Sachs noted that the sharp uptick in retail trading helped increase the valuation of some popular retail stocks 13 points higher than the broader S&P 500. That might be good and well as stocks continue to erase their steep losses from early in the pandemic, but there may be serious problems when the tides turn and the market crashes.

“This reminds me of the tech bubble, when my mom was buying stock she had no idea about. So if we do have a day of reckoning, you’ll see some people getting shaken out,” said Goldman.

Trading professionals have a term for retail or individual investment: dumb money.

“I think the perspective is that sophisticated, institutional investors have computer power, analytics, schooling and education, and have been able to build portfolios over the long terms, where the dumb money is the people chasing returns,” said Goldman. “The average retail investor is the ‘dumb money’ because they’re not sticking to the long-term investment plan like institutional investors.”

Goldman adds that the impact of dumb money on the markets is apparent because individual investors tend to flock to a certain class of stocks and avoid investments institutional investors keep in their portfolios. Those “smart money” investments are seeing less demand than the more popular kinds of stocks.

That isn’t to say that people cannot make good or profitable decisions making individual trades. Instead, it points to the lack of regulation or guardrails around an activity that with modern technology has become a gambling game.

“People are out of work, or working from home with no sports to watch, so they’re speculating on stocks for entertainment during a period when the market has had a huge upswing, so they feel smart,” said Nick Juhle, the director of investment research at Greenleaf Trust, a wealth management firm.

One example that has gained some notoriety is individual investors recently piling into Hertz stock after it filed for bankruptcy. As thousands of Robinhood traders poured in to make a quick buck, the stock price rose from just under $1 to more than $5. The stock is currently trading at about $1.59, and its value may be completely wiped out as the company’s bankruptcy proceeds.

Robinhood says its platform broadens access to those who have been traditionally shut out of investing in markets, which can be a source of wealth creation.

“It is not lost upon us that our company and our service have become synonymous with retail investing in America, and that this has led to millions of new investors making their first investments through Robinhood,” a Robinhood spokesperson said.

“We aim to provide the best investing experience as well as the resources customers need to get and stay informed,” they added.

But where some analysts see the rush of retail investors as pushing up markets, Juhle noted that the effect is small relative to other factors.

“On the margin, it might be adding a small amount of volatility in sectors that are already volatile, such as the travel and leisure industries, but on the whole I don’t believe it is having any meaningful impact on the markets,” he said.

When compared with the trillions of dollars the Federal Reserve has pumped into the economy, the gargantuan stimulus packages Congress has authorized, the low interest rates and the unclear trajectory the economy will take in the coming months, the rise of Robinhood investors is on a decidedly lower order of magnitude.

“We’re in the worst economic period in a century, and yet the market refuses to go down, and that’s because the Fed has injected it with a dose of heroin that’s making it behave as though it’s 1999,” Rowady said.

“It’s absolutely a bubble. We just don’t know when people will take their chips off the table. It may be when they realize they need to live on their savings,” he added.

Updated at 9:17 a.m.


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