Robinhood Effect on Stock Market

Robinhood Effect on Stock Market: It’s an unusual time in the US economy. There was a massive stock market crash, which rapidly rebounded. However, millions remain unemployed and entire industries are in distress.

Hedge funds are scrambling to generate their customary returns, and investors, analysts, and experts are in a heated debate over near-term market prospects. Will there be another crash? If so, when? 

The oddest twist in this story is which group is currently leading the pack in terms of profiting from stocks. It’s not who you would expect. While those who have devoted decades to their financial services careers struggle, a large collection of amateurs have used their quarantine time to explore day trading through no-commission apps like Robinhood.

Against all odds, some are pocketing substantial profits. Most shocking of all, they are beating the professionals in terms of profit by a wide margin. 

Not only are some amateur Robinhood traders making money – as a group, they are creating enough traffic to impact entire segments of the market.

As a result, large investors are quickly learning that their traditional techniques for riding out volatile markets won’t work.

This phenomenon, now referred to as the “Robinhood Effect”, is challenging the status quo and driving significant changes in the strategies available to experienced investors. 

In short, the Robinhood Effect is a term that describes irrational stock price movements caused by retail traders buying stocks without regard to their fundamentals.

How the Robinhood Effect Began

Not long ago, stock market investing was limited to those who could maintain certain balance requirements in their brokerage accounts and afford related commissions and fees. All of that has changed in the past decade. A crop of discount online brokerage services, like Robinhood and tastyworks, found the right formula to attract an entirely new set of traders. 

They did this by taking trading online. They created easy access through mobile devices, and introduced a class of automated, self-directed account types that include little or no interaction with professional advisors. Minimum balance requirements have been reduced or eliminated, as have commissions and trading-related fees.

Further, fractional shares are now available, which dramatically changes the dynamics of trading for novice traders with tiny portfolios. 

Removing these barriers to entry is just the beginning. Services like Robinhood, which launched in April 2013, vowed to democratize investing by simplifying the concepts and offering extensive tools and resources for education and research.

They set up sites and apps with entertaining interfaces that transformed complex financial transactions into something of a game. Again, all of this is automated and self-directed. 

While the outcome is precisely what Robinhood and peers were after – a massive influx of young, amateur traders utilizing the platform – no one could have predicted the market impact.

Today, a large group of inexperienced traders is exerting power in the marketplace. Financial services professionals, institutional investors, amateur traders, and the platforms themselves are now trying to work through the unintended consequences of opening the market to anyone with a mobile device and a few dollars to gamble.

Robinhood Traders Move The Stock Market

In the first quarter of 2020, Robinhood added three million accounts. The sudden jump has been attributed to the combination of a decline in the market, unprecedented lockdowns, quarantines, and stay-at-home orders, and an influx of cash from direct government stimulus payments. 

Companies that were once out of reach for the average household became affordable, and everyone from college students to the newly unemployed had more time on their hands to explore available opportunities. Perhaps more importantly, government stimulus payments were issued shortly thereafter, and beginners with little or no cash to speak of found themselves with a bit of capital to play with. 

Retail accounts make up approximately 37 percent of the total brokerage market, and Robinhood holds a small but growing share of that business. While the majority of retail traders mirrored professional and institutional investors in selling their at-risk shares during the height of the downturn, Robinhood traders took a different approach. 

Under theories like “don’t fight the Fed” and the coarser “#BTFD (Buy The F***ing Dip)” these new investors are pouring cash into distressed industries. They are betting that prices will rebound, particularly given various government bailout programs in place, and they plan to profit on the way up. 

So far, the strategy is working for a good number of Robinhood traders. Their purchase of small, inexpensive companies is generating solid returns.

Financial giant Barclays observed that the 25 smallest stocks in the Russell 2000 index returned an average of 124 percent since the March market crash, while the index’s 25 largest companies have only returned an average of 28 percent. 

Some analysts believe amateur Robinhood-style traders are responsible for part of the market rally – particularly among hard hit airline and cruise stocks – and they are struggling to interpret the impact.

Because Robinhood traders aren’t behaving the same way as more experienced investors, shares of the companies they have selected aren’t behaving as they normally would. 

Risks of Robinhood Effect

Though Robinhood traders are experiencing some success, the risks associated with this type of amateur trading are significant.

The amounts being invested are small as compared to the massive funds controlled by professionals, but amateur investors are still gambling their life savings in an arena they don’t fully understand.

They are acting on “hot tips” they find on social media or buying into the “trending stocks” listed in their Robinhood feed. They generally aren’t completing the sort of in-depth research necessary to choose smart investments, and a total loss is not out of the question. 

Aside from that, Robinhood traders aren’t just buying and selling stocks. They are experimenting with sophisticated options strategies and short sales that are considered high-risk regardless of experience level.

Though Robinhood does offer investor education, amateurs tend to lack foundational knowledge and the sort of skill that comes with experience. They don’t fully understand their positions, and they are missing the sort of basic technical information that professionals rely on to ensure their trades run smoothly. 

The most tragic example of these risks was the June death of 20-year-old Alexander Kearns. Kearns took up day trading to pass some time while in quarantine, and he worked hard to understand and apply various options strategies that offer a hedge against loss.

However, a misunderstanding in how he read his account balance led him to believe he lost a shocking $730,000. Before the misunderstanding could be cleared up, a despairing Kearns died by suicide. 

Fallout From Robinhood Effect

It’s hard to say how the Robinhood Effect will impact investors’ behavior long-term. It’s not unreasonable to think that amateur investors with these sorts of accounts will eventually lose interest and move on to other forms of entertainment when daily life regains some semblance of normal.

However, it’s also possible that Robinhood-style investors are here to stay, which leaves the professionals to integrate the Robinhood Effect into their strategies for portfolio management. 

For now, those professionals are dealing with the fallout of failing to predict how the market would move. While a respectable portion of Robinhood’s amateur traders profited from the market’s fast rebound, many experienced portfolio managers missed the rally.

This sparked endless dissension and debate among investors and analysts across the board. Some are furious with the amateurs for disrupting semi-predictable activity patterns, while others admire their success and want to be a part of it. Needless to say, the uncertainty is a source of great anxiety. 

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.