Fears About Robinhood are Overblown, New Stock Trading Platforms Are Here to Stay

Last year’s Gamestop scenario has ignited fears about phone app trading, but these market problems always existed in some form or another.

Concerns raised about Robinhood

Authorities ranging from investor advisors to financial reporters to the Biden Administration’s SEC Chair have all been warning of the dangers involved in the trading platform Robinhood. Concerns include luring novice investors who are at risk of being taken advantage of, increasing gambling behavior in the stock market by gamifying trading, and the payment for order flow funding business model that allows for commission-free trades for the users.

Pandemic lockdowns meant that a lot of Americans had more free time on their hands and stimulus checks meant they also had more disposable funds to use in trying their hands at investing. At the same time, many avenues of traditional gambling (casinos, major sporting events etc.) were all temporarily paused by the pandemic. There are signs that suggest some habitual gamblers may have shifted into the equity market to fulfill their gambling fix. Gaming-related stocks like Penn National Gaming (PENN), a racetrack and casino operator, and DraftKings (DKNG), a popular sports betting platform, saw a spike in interest soon after the start of the pandemic. Traditionally sports-oriented media platforms like Barstool Sports pivoted to stock market coverage.

While there is good reason to assume that many of these new investors used Robinhood or other free trading platforms to make their investments as they have the lowest barrier to entry, there is no evidence to show that Robinhood itself had any impact on changes to the trading behavior of its users.

Why cognitive biases and the ‘gambler mentality’ have always existed in the market

The other point worth making with regards to the worries surrounding free trading apps is that the new entrants into the market are a drop in the bucket when compared to the market at large. Existing investors in the market already exhibited high levels of gambler mentality.

Cognitive biases are also not unique to retail investors. There are a number of biases that we all exhibit from time to time and some of them have a tendency to impact investment decisions negatively. Even institutional investors who are aware of these biases still have to implement specific measures to make sure they correct for those biases in making investment choices and even said measures do not guarantee biases will be mitigated.

As a species that relies heavily on cognitive ability for our evolutionary success, it’s no surprise that many human adaptations have come in the form of psychological mechanisms. Those adaptations have come alongside the development of biases which are easily misconstrued as evolutionary mistakes but are in fact processes that helped our ancient ancestors survive; it just so happens that some of those same mechanisms, when applied to certain modern contexts, end up hampering our rational decision-making ability.

One example of this is the overreliance on heuristics in making complex decisions. Throughout our history, humans have needed to make decisions when they didn’t have enough information to properly assess the circumstances. Our ancestors may not have had a way to measure the flow rate of a river to determine if it was safe to attempt across, but they were able to determine it was safe if the reeds on the banks were still standing up straight.

This adaptation helped primitive humans immensely as they were able to rapidly identify signals to help make inferences about more complex, immeasurable phenomena. The problem is that as humans developed this skill, a tendency to search for and latch onto heuristic indicators was also created. In modern scenarios such as investment decision-making, the variables are far too complex for there to be anyone indicator that can consistently signal coming market shifts.

In addition to the overreliance on heuristics, investors are also prone to overconfidence and herding biases. The first being when individuals think they have the ability to time the market and predict when it is going to go up or down. This often happens when investors experience early success or find a new source of information that initially proves predictive. The error in the bias is to cause the investor to think that the same source or method will work in perpetuity. Herd mentality - or “bandwagoning” - bias is another prevalent bias common among investors. With the rise of investing influencers and an increasing number of investors reporting that they got their information from social media investment “gurus”, many are prone to latching on to popular stock opinions and moving with the crowd. The recent phenomenon of FOMO trading, where investors are afraid of missing out on the next big stock win, is a form of herd mentality or bandwagoning.

Why people will continue to have these behaviors regardless of platform

Human beings and the way we interact with technology constantly changes. No person or platform is more or less susceptible or prone to cognitive biases. When a new platform or technology exposes existing biases and their impact on investor irrationality the response should not be to get rid of the platform, it should be to work to better understand the exposed biases in order to help correct for them. Platforms exist that allow you to see the impact biases may have, either tools that analyze investor behavior to determine how much of a stock’s price, funds that track this data in their investment decisions, or groups who advise based on market behavior.

Free trading platforms have expanded market access to new people. Whenever a large group of new traders enter the market institutional investment managers are likely to struggle initially to understand the behavior of the newcomers. Most evidence shows that while some newcomers have fallen victim to common cognitive biases that result in irrational decisions, others have illustrated an ability to understand some market fundamentals. For the most part retail investors on free trading apps bought the dip caused by the pandemic with the same amount of success as their institutional counterparts, but everyone is a genius in a bull market. It remains to be seen how many among the latest wave of self-directed investors will maintain a high level of success under more volatile conditions.

How Robinhood has remained so popular despite controversy

Robinhood and other free trading platforms have come under fire recently from a number of different angles. The Biden administration’s SEC has said its payment for order flow funding model misleads investors despite the fact that many other broker-dealers use the payment for order flow. Institutional investors say that they are drawing in inexperienced irrational actors to the market. The trading software’s own users and internet stock influencers criticized its platform for shutting down certain trades amidst a run on Gamestop stock earlier this year. Despite these controversies, Robinhood has continued to gain new users. The desire to privately acquire stock in the company ahead of its expected IPO continues despite the company paying a $70 million fine for some of its previous practices.

Financial media outlets that were deriding the rise of retail investors and free trading platforms a year ago are now publishing articles giving direct advice to Robinhood traders. The popularity of these platforms grew so quickly that they now represent a significant portion of some parts of the market, commission-free trading platforms and the investors using them are likely here to stay.

To protect themselves, investors need to learn about the cognitive biases that impact themselves and the other investors in the market. Behavioral analytics tools and funds should be utilized and monitored to avoid falling for stock prices that are either inflated or depressed by market irrationality. New investors can look to experts to learn investing strategies and best practices but should be wary of anyone purporting to be able to predict the market and tell the masses which specific stock moves they should all collectively be making.

The pandemic and resultant economic shutdown created the perfect scenario for retail investors to get into the stock market when many major companies were selling well below their normal values. This democratization of equities trading will be hard to reverse--Pandora’s box is open and there’s no going back. The Focus should be on arming new investors with the resources they need to protect themselves from being taken advantage of as stock trading evolves with new technologies.

Written by: Mahesh Kashyap and Mark Gorzyscki