During the pandemic, ordinary people piled into stock markets, many for the first time in their lives. Between January and September, big US retail brokerages E*Trade, TD Ameritrade and Charles Schwab saw the total number of average daily trades increase by three quarters to six million, according to Sundial Capital Research.

Lockdown boredom is one explanation for this trading surge. Another is the relative lack of sports betting opportunities and the hunt for returns amid record-low interest rates.
As newcomers flooded into trading, they were drawn to one platform in particular. Robinhood, one of the most high-profile trading apps, reported three million new accounts in the first quarter of 2020. Half of these were first-time traders.

Robinhood’s mission is to “democratise finance for all,” according to the Californian start-up’s website. Many studies show us that one of the best ways for an ordinary person to accrue wealth is to invest for the long term. Historically, however, the young and the less affluent have been excluded from the world of investing due to a lack of capital, lack of accessibility and poor financial education.

Online platforms have changed this. “They’ve democratised finance, taking away power from typical city-slickers and giving it to investors instead,” said Andy Bell, chief executive of AJ Bell. “Investing is much more accessible to retail investors when it’s a couple of clicks away online. Previously, opening an account to buy and sell shares would have meant arranging a meeting with a stockbroker and going through reams of paperwork. Now you can be trading within a few minutes.”

It’s this anti-establishment narrative that has helped Robinhood draw in many young people disillusioned with the world of finance in the years after the financial crisis. But this idea isn’t as revolutionary as it sounds; it’s the latest iteration of a trend seen many times throughout history.

A look back in time
Robinhood is far from the first brokerage to attempt to ‘democratise’ investment. After the Second World War, Charles Merrill – the co-founder of brokerage Merrill Lynch – set out to “bring Wall Street to Main Street” by selling stocks and bonds to middle-class investors. Realising that a lack of financial education was one of the main obstacles preventing affluent people from investing, Merrill Lynch published easy-to-read pamphlets on topics like ‘hedging’ and ran a full-page ad in the New York Times entitled, ‘What Everybody Ought to Know About This Stock and Bond Business.’ It also became one of the first Wall Street firms to open branches in smaller cities.

Companies are competing to be the most transparent with their customers and offer better customer service

Despite this and despite the growing affluence of US citizens through the 1940s and early 1950s, relatively few owned stocks. The Brookings Institute produced a report in 1952 that estimated that the number of US adult shareholders was just 6.49 million in 1951 – half the amount recorded in the early 1930s.

The Cold War proved a key turning point in public attitudes towards investing. Between 1954 and 1969, the New York Stock Exchange ran a major advertising campaign called ‘Own Your Own Share of American Business,’ in which it promoted investing as a capitalist defence against the threat of communism. The campaign was highly effective. By 1970, there were 30 million shareholders in the US. This was also driven, in part, by stock splits that made round lots affordable for small investors.

Another key turning point came with the digitisation of investment platforms. Electronic trading systems enabled consumers to bypass the trading floor, making it more affordable for them to invest.

“Access to trading has gotten easier and cheaper. You can open an account at a discount brokerage with just a few clicks,” said Andreas Park, Associate Professor of Finance at the University of Toronto. Even before lockdown drove novices into the world of trading, investment platforms were growing. Around the world, more than 100 million people trade and invest online.

But the secret to Robinhood’s success isn’t just a user-friendly online platform. The start-up is famous for removing some of the main financial barriers to trading. For example, in 2019 it launched fractional share trading, enabling traders to invest in stocks and ETFs with as little as $1, regardless of the price tag of the shares. “The chance to buy fractional shares makes trading easy and accessible for anyone,” said Inga Timmerman, Professor of Finance at California State University, Northbridge.

Acquiring new customers
But Robinhood’s most significant customer acquisition strategy came earlier on, when it pioneered the zero-commission model. The elimination of fees for stocks is a core factor in allowing the newcomer to acquire over 13 million users in just seven years.

When the effectiveness of this strategy became clear, major brokerages followed suit. In 2017, Charles Schwab slashed its basic fee for trading US stocks and exchange traded funds to $4.95. Two years later, it cut commissions altogether, along with E*Trade, TD Ameritrade and many other major brokerages.

A high tolerance for risk can be dangerous. In falling markets, people can get wiped out

“We are seeing new firms trying to enter our market, using zero or low equity commissions as a lever,” Peter Crawford, Schwab’s chief financial officer, told the Financial Times. “We don’t want to fall into the trap that a myriad of other firms in a variety of industries have fallen into, and wait too long to respond to new entrants.” But investors weren’t too pleased with the brokerages’ decision. E*Trade generated about 17 percent of its revenue from commission; for TD Ameritrade, the figure was 28 percent. Because of this, the share prices of both brokerages plummeted in the aftermath of their announcements.

In a matter of years, Robinhood had turned the business model of investment firms upside down. As Bell points out, this price war has in many ways benefited consumers. “Not only has competition from online platforms driven down the fees,” he said, “but companies are competing to be the most transparent with their customers and offer better customer service.”

The real winners
But by far the biggest winners in this scenario are market makers. In lieu of commissions, brokerages rely on payment for order flow (PFOF) in order to make a profit. Market makers like Citadel Securities will pay brokerages millions for this order flow. These firms then pocket the difference between the price to buy and sell, known as the spread.

Market makers are now cashing in on the boom in retail investing. High trading volumes – driven by market volatility and the influx of new investors – have increased the raw materials market makers need to make a profit, while also forcing spreads wider. Citadel Securities doesn’t share financial data publicly, but experts predict that its earnings have leapt.

Arguably, its success on the back of Robinhood would seem to undermine the platform’s mission to ‘democratise investment.’ Critics of PFOF argue that it just makes wealthy executives wealthier. After all, Citadel Securities is run by the richest man in Illinois.

The practice has come under scrutiny by regulators around the world, who worry that it could create an incentive for brokerages to send orders to whoever pays the most instead of looking for the best outcome for the consumer. Canada has banned the practice outright. Robinhood itself was fined $1.25m by the Financial Industry Regulatory Body in 2019 for ‘best execution’ violations.

Market makers defend themselves by claiming they offer a better price than the market does, on average. However, the profit they’re generating off the back of Robinhood calls into question who the start-up’s real customers are, and whether the firm is really motivated to do the best by its users, as it claims.

Novice investors
As Timmerman points out, the economic instability caused by the pandemic makes this a prime time to invest. “When volatility is high, like it has been for the last year, we realise that we have an opportunity to make money by trading,” she said. “Additionally, an event like the pandemic creates an opening for more stock picking as we can decide which industries will do well and which will not.”

Many of these new investors are millennials. Wealthsimple, another online investment platform, says that over half of its new customers are under 34. Worryingly, there is evidence that some of these new young investors may be taking riskier investment decisions than those who’ve been in the game longer. According to a 2018 survey by CFA Institute, less than half of millennials with taxable investment accounts are “extremely or very confident” in their investment decision-making abilities.

Many regulators still think there should be more protections for investors in ETFs made up of riskier assets

And the pandemic may have inflated this confidence. According to data by E*Trade, more than half of investors under 34 said their risk tolerance increased during the pandemic, whereas only 28 percent of the general population said the same.

A high tolerance for risk can be extremely dangerous though. “In falling markets, people can get wiped out,” said Park, “in particular if they used financial products that they don’t understand, such as margin accounts, short positions, or futures and options. They’re not for everyone, and things can go badly wrong.”

Some of these traders may be better off passive investing, Park argues. He refers to a 2000 paper by Brad Barber and Terrance Odean, published in the Journal of Finance, entitled ‘Trading is hazardous to your wealth.’

“The authors found that market returns exceed the returns of those who trade the most by 50 percent,” he said. “So, while those folks made money, they would have been better off buying an index fund.”

A dangerous game
It’s worth remembering that millennials still hold only a tiny percentage of global wealth. In the US, they own just seven percent of total assets, compared to the 26 percent owned by baby boomers when they were around the same age. Without the benefits of low housing prices and the more competitive salaries that their parents enjoyed, investing could be a good way for millennials to close this gap – if only marginally.

In some countries, governments are actively encouraging people to participate in long-term investing. France’s state-backed investment bank BPI has launched an innovative fund to provide access for retail investors to private equity strategies, for instance.

Park points out that the argument that young traders don’t know what they’re doing is an oversimplification. “If experience would matter, then trading desks at banks would be stacked with 50-somethings, right? Where are they?” he said. “A colleague of mine ran trading cases in which he let professional traders operate in an environment where the price was determined by a computer that was programmed to run a random walk, so the price movements were unpredictable.

The professional traders insisted that they could tell when the market would move up or down. Of course, they could not. What matters is knowledge and understanding and really that often boils down to staying away and knowing that it’s pretty hard to beat the market.”

It’s this knowledge and understanding that novice investors sometimes lack. And platforms like Robinhood aren’t doing enough to improve this. In fact, by gamifying trading, these platforms are potentially hooking young people on high-risk financial products. In some ways Robinhood’s interface more closely resembles a social media app than an investing platform. There are bursts of confetti when a transaction is made. Users can tap up to 1,000 times a day to try and rise up the waiting list for Robinhood’s cash management feature. These in-app rewards can lead traders to return to it again and again, encouraging excessive trading.

Real-world consequences
Already this has had grave consequences. In June 2020, a 20-year-old student, Alexander Kearns, killed himself after mistakenly believing he had lost $730,000 through Robinhood’s app. The misunderstanding came down to a user interface issue; during options trading, the cash and buying power will sometimes display as negative until the other side of the trade is processed.

Robinhood responded to the tragedy by saying it would change the way buying power was displayed on the app, as well as adding in additional features to help users better understand how options trades work. “These changes will take a bit of time to roll out, but our teams are hard at work,” the Robinhood co-founders said in the blog post. But Kearns’ death brought to light the perils of trading in a vacuum, with only an app to consult for advice. Many are now calling for these start-ups to be more closely scrutinised by regulators.

It’s not just traders who can suffer as a result of impulsive investment decisions. There are also real-world consequences to these actions. Market speculation can fuel dangerous levels of volatility. Last year analysts attributed the market rally that took US benchmarks from corrections territory in March to an all-time high in August to risk-taking millennials and a bullish options market.

Speculation also led to a massive plunge in the West Texas Intermediate (WTI), the US benchmark for oil, in April. At the start of the pandemic, United States Oil Fund (USO), a hugely popular exchange traded fund (ETF) that deals in oil futures, absorbed $5bn from investors. This drove USO to purchase more futures until it accounted for about a quarter of all May and June contracts for WTI. Its outsized position gave it an outsized influence on oil prices, which plunged into the negative. Commodity prices can have a huge impact on the global economy. Nowhere is this truer than in the oil market.

Sharp oil price changes have knock-on effects through the economy, affecting everything from employment to trade balance to inflation. According to Robinhood, USO was the most purchased stock by the broker’s 10 million users on April 21. The size of the fund more than doubled that month. But many of these investors had made a mistake.

Losses in excess of equity
They thought the fund was a proxy for the price of oil and rushed to buy the fund as its value plummeted by 37 percent in the first three weeks of April, convinced they would cash in when prices recovered. They didn’t realise they were not trading in oil prices, but the futures market. Many traders made huge losses as a result. Interactive Brokers Group said it was taking an $88m hit after customers incurred “losses in excess of the equity in their accounts.”

The trend towards retail investors speculating in complex markets is cause for concern. Investment products linked to commodities futures are considered by regulators to be particularly risky. So, while democratisation of investment might sound good in theory, uninformed retail investors pouring into this market may not be so positive in practice. In 2019, the Securities and Exchange Commission (SEC) proposed that retail investors should only be allowed to buy and sell leveraged ETFs if their broker or investment adviser had first carried out checks to ensure that their clients properly understood the risks. But the proposed sale restrictions sparked disagreements among top US regulators and have since been dropped. Many regulators still think there should be more protections for investors in ETFs made up of riskier assets.

After the pandemic
Thanks to online trading platforms, more and more ordinary people are investing in stocks and ETFs. The pandemic has only accelerated this. The question now is whether the trend will outlast COVID-19. Timmerman believes it will. “I see it as a long-term pattern primarily due to the accessibility that websites like Robinhood offer retail investors. The volume will most likely go down (as it does when things in the stock market do not go up) but the overall increase in the volume of retail trading is here to stay,” she said.

From one perspective, platforms like Robinhood have helped to democratise investing, as they’ve empowered young and less affluent traders to generate wealth. But they’ve also left these traders exposed. It’s clear from Kearns’ death that the gamification of equity and options trading poses risks to uninformed investors. Although SEC proposed improvements to the retail investor experience in the aftermath of his suicide, these arguably don’t go far enough.

However, there is another real-world benefit to the increased accessibility of trading. In a very short space of time, millennial investors have had a huge impact on Wall Street and the way its firms operate. They’ve driven brokerages to cut commission and upend their business models. They’ve pushed them to invest more heavily in online platforms.

They may also convince these companies to offer more environmentally and socially sustainable investments. According to Morgan Stanley, under-35s are twice as likely to sell a holding if they behave unsustainably. Millennial investors are changing Wall Street. In some ways, it may be for the better.