Back in the day, I recall a globe-trotting portfolio manager telling me that whenever cab drivers — remember them? — starting asking for stocks tips, he knew it was time to get cautious.
 

Small Investors Tend to be Late to the Party

That comment references the popular view that small investors tend to be late to the party, i.e., often buying near bull market tops. It’s also a reflection of the tendency of some investors to trade too much. Those are generalizations, of course, but are a fairly accurate description of investors who trade frequently on what amounts to guesses about a stock’s near-term direction. All of which is by way of addressing one of the more interesting investment stories of recent years, but especially of 2020: the popularity of the Robinhood trading app that has attracted millions of new investors, many of them young, inexperienced and with extra time on their hands during pandemic-induced lockdowns (see Websites of Interest).
 

Robinhood’s runaway popularity

There are several important takeaways from Robinhood’s runaway popularity: First, those mostly small investors seem to have done better than their caricatures as momentum-chasing, hot-stock speculating novices would suggest. In fact, academic research by UCLA finance Professor Ivo Welch determined that returns extrapolated from Robinhood accounts over the roughly three-year period through August 2000 did well relative to many of their more experienced Wall Street counterparts.

 

The Ability to Trade for Free

But the ability to trade for free — an option that is now widely available from nearly all online discount brokers — has created the potential for investors of all ages and experience levels to dig a financial hole for themselves that could be nearly impossible to escape. 

Though Robinhood makes some of its money on margin loans, and while the brokerage strives to promote prudence and scrupulously avoids recommending stocks, those drawn to the thrill of the casino rather than to simply building long-term wealth could get themselves in trouble. “At least part of Robinhood’s success appears to have been built on a Silicon Valley playbook of behavioral nudges and push notifications, which has drawn inexperienced investors into the riskiest trading,” according to a recent New York Times article. The Times reported that, adjusted for account size over the first three months of 2020, Robinhood customers traded 40 times as many shares and 88 times as many risky option contracts as Charles Schwab customers.

 

The Addictive Lure of the Quick Buck

Young people could be especially vulnerable to the addictive lure of the quick buck, a prospect that at least one money manager — without referencing any specific brokerage firm or app — thinks has contributed to valuation-driven distortions in the U.S. stock market.  

On balance, it is welcome news that young people are getting more involved in owning shares of American businesses. Given the power of compounding, putting money to work early in life is key to building long-term financial security. Still, it can be a challenge for parents to encourage their kids to invest without also inciting the gambling instinct that resides in many of us. A good place to start is to sit down and talk with them about the stock selection tools relied upon by readers of this maga-zine, and then together to identify companies that they like, use or follow that meet those guidelines. There is useful information online that can help parents get their children interested in investing and off on the right foot. 

Owning a familiar business can make the world seem real to kids and young adults. It also can illuminate career pathways. If so, that might be the real legacy of the current Robinhood phenomenon.