Terrance Odean, the Rudd Family Foundation Professor of Finance at the Haas School of Business at the University of California, Berkeley, joins Morningstar’s The Long View podcast to discuss his research on individual investor trading, Robinhood, and the effects of social media on individual investor decisions.
Here are a few excerpts on gamification and Dr. Odean’s research on the “herding” phenomenon from his conversation with Morningstar’s Christine Benz and Jeff Ptak:
The Gamification of Robinhood
Benz: I wanted to talk about the gamification aspect of Robinhood, which has been much discussed. You wrote that gamification and simplicity can influence trading behavior in ways that might redound to the detriment of investors. Could you expand on that?
Odean: Yeah, sure. So first of all, it’s a great opportunity for me to mention that, that research, that paper was written with Brad Barber, and Xing Huang, and Chris Schwarz. So those are my co-authors. I appreciate the opportunity to talk with you. But the work on Robinhood is with my very good co-authors. The gamification well, I’ll tell you question that I ask my students. And it’s a question I think, generally people should ask when they’re doing any trade that is somewhat speculative. And what do I mean by speculative? I mean, you’re buying a stock or an option or an ETF because you think it’s going to outperform the market over a relatively short horizon, as opposed to what I think of investing, which is you’re buying the S&P 500, or you’re buying a well diversified portfolio that you intend to own for many years. Because you think in long run the U.S. economy is going to do well and that will be reflected in the market prices.
So if you’re speculating, if you are buying a futures contract, or even just speculating on a stock, a reasonable question is who do I think is on the other side of this trade? And in the U.S., most likely, the counterparty, the person on the other side of your trade is going to be a professional trader, probably actually, very likely a computer programme owned by a big trading firm that consistently makes money. So you can say, well, why is this person trading with me? And if you and why is it that I think I’m going to do better on the trade than this person who is making — this company that is quite profitable by trading with people like me? And that can be a tough question to answer. I’m not saying there’s never a good answer. But more often than not, the answer is, realistically they’ll probably do better on this trade than I will.
Now, when you pull out your phone, and you place a trade in an environment that almost looks like a simple game, there’s more of a sense of it’s me against the game. And you think, well, you know, I’ve beaten games before, if I keep practicing, I’m going to get, I’ll get better at this. It feels more as if you are competing, not with a person, but with a gate with something, that you can perhaps learn to outsmart or outplay. And that’s not the case. This isn’t, there are a lot of little games, you can play on your apps and on your phone. And as you get better at playing more and more, you’re likely to get better and better and start winning more. When you’re placing trades in the market, you are consistently trading with financial professionals, usually large trading firms. And in most cases, the retail investor is going to do less well in the long run.
And that’s not — I am not at all trying to say that retail investors always lose. That’s not true. And I’m sure if I said such a thing, I’d get a lot of email telling me I was wrong. But I also know that on average, that at least historically, they have not benefited from active trading. And I have studied, I’ve analyzed data sets at different times, in different countries. I’ve read many studies written by colleagues who have analyzed the trading of retail investors at different times and in different countries. This is a consistent finding.
Should Individual Investors Buy and Hold?
Benz: Well, I wanted to follow up on that, because it seems like the only really notable advantage that the small individual investor has is sort of a long holding period or you know if they can be patient, that’s maybe an edge that they have versus professional investors who might have outside pressures to perform a certain way or whatever. How come so few individual investors get that memo that if you want to buy individual stocks, you should buy and hold and hold and hold.
Odean: Well I don’t know how many do, right. Because we don’t talk about them as much. So undoubtedly, there are many individual investors who are buying and holding mutual funds and there are probably many who are buying and holding individual securities. My dad died, I think about half a dozen years or so ago. Firstly, for me, my brother dealt with most of the estate issues, but he found investments in individual stocks that my dad bought in the 60s. So, he was apparently a buy and hold investor of individual stocks. I think there are a lot of people out there who are patient and sit on portfolios, not necessarily mutual funds. But we don’t talk about them as much in podcasts because, they’re not doing much or you can say what they’re doing is a good idea, but you know, there’s not much to say like, good strategy.
So Robinhood is new, there are more than 20 million people who’ve signed up with Robinhood. And many of them in the last few years, we’ve observed a surge in retail trading in the last couple of years, it’s that surge in retail trading quite likely has contributed to higher market prices. So it’s newer, it’s more exciting. And there’s a lot of people doing it. But I suspect that there are also a lot of people out there who are taking more patient approach.
What Is “Herding”?
Ptak: You mentioned a few of the things that seem unique about this moment that we’re in simplification of interfaces, gamification of the experience, another I suppose you could argue is herding. We’ve seen this with subreddits, and meme stocks, crypto NFT. You name it. But I think you’ve called, you’ve described this sort of thing as a herding effect, and in particular, I think you’ve observed this at Robinhood. And you’ve noted that herding, these periods tend to be associated with large, negative abnormal returns subsequently. So can you talk about what herding is, as you’ve defined it, and also the return pattern that seems to follow from it?
Odean: Sure. So there is an interesting change. Now, it’s been true for a long time, that investors, not only individual investors, but to a larger extent, individual investors, herd in the sense that they tend to buy the same stocks as each other at about the same time. So I’ve written about this in the past, I mean, well over 10 years ago, probably 15 years ago, Ning Zhu, Brad Barber and I wrote a paper looking at this. And it was certainly true in the, you know, the dotcom bubble that you saw the individual investors, many of them buying the same stocks at about the same time, but there is a fundamental change.
So back in, you know, the early 90s, or the 80s, or the 70s, or the 60s, it was very difficult to observe, to know what other investors were doing directly, you could observe that the stock, a stock had gone up, and you bought it, you buy it, because it went up, and then other people buy it because it went up. And so you end up with herding because individual investors were more inclined to chase returns than retail investors, or investors could all read about the same stock and decide, oh, wow, I just read about pets.com. That sounds like a fabulous idea. I think I’ll buy it. And other investors read the same article and buy the same stock. And so you got herding, because retail investors were responding to the same signal.
What’s changed is now with Reddit, subreddits, like WallStreetBets, you can see pretty much in real time, what other investors are thinking, what they’re at least writing, and why — people are saying, I’m buying this, this is what I’m buying at. So that the term herding comes from herds, like herds of buffalo. And, you know, where all the animals are running the same direction. And to some extent, they are following a few leaders. And if those few leaders move, they all change the direction at the same same time.
So I think today because of social media, it’s actually herding is more like those, the potential for herding to be like the buffaloes more there. It’s the idea that I’m doing something because I saw someone else like me do it. As opposed to I’m doing something because I read an article and thought, oh, I want to buy this and this other person read the same article. Now I’m reacting to this other person’s comments. This other person’s, what this other person says he or she is doing. And that’s both intensified the amount of herding and again by herding I mean a lot of retail traders buying or selling but usually the herding is more intense on the buy side, the same stock, at the same time. It’s intensified it and it’s also shortened the time frame.
So if you were reacting, buying stocks because they went up, then at least investors, some investors would buy a stock the day you’d read that the price have gone up, you buy it the next day, that pushes the price a little higher, other people buy it the day after that. Or if there’s an article that you all read, you know, in the newspaper, there’s still a little bit of a lag in how long the period over which this herding takes place. Now can be extremely fast, it can be minutes or hours. And so when we looked at the trading, and looked at the reactions of new traders on Robinhood investors buying a stock for the first time. We found days where the number of Robinhood investors that own a stock went up many times in that same day. And generally what we found was that such events had a pattern where the stock price went up a lot. There was a great deal of buying near the peak, and then the stock price went down but not down to where it had begun.
So to be clear it would start low, go very high and then come back down. As best we could estimate, on average, these investors were losing money because so many of them in this particular trade. I’m not talking about the rest of their portfolio, but in this particular trade over a short horizon because so many of them were buying near the peak. Now, undoubtedly, the people who got in on this herding event early, many of them would have made money. To us it was sort of like, you know, there’s a party going on. And but what if you are one of the people who at about midnight or one o’clock your room, oh, there’s a party over on Fourth Street and you get to the party. And you get there, just as you see people are starting to leave, before the police show up to tell everyone to turn the music down. You’re a late arrival, and you don’t get to really enjoy the party. I think that’s somewhat analogous to what happens in these herding events that the people who arrive at the party late end up not having as much fun.
This article was adapted from an interview that aired on Morningstar’s The Long View podcast. Listen to the full episode.