How Robinhood Plays With Your Attention And Makes You Lose Money

How Robinhood Plays With Your Attention And Makes You Lose Money
Stéphane Renevier, CFA

over 2 years ago5 mins

  • Ebrokers ain’t investors’ friends: they use all sorts of tricks and features to incentivize you to trade more.

  • That makes you more likely to be influenced by your behavioural biases, and to buy the same stocks as everyone else at the same time.

  • And since this herding behaviour leads to large losses for investors, you should protect against it by creating a checklist before making a trade.

Ebrokers ain’t investors’ friends: they use all sorts of tricks and features to incentivize you to trade more.

That makes you more likely to be influenced by your behavioural biases, and to buy the same stocks as everyone else at the same time.

And since this herding behaviour leads to large losses for investors, you should protect against it by creating a checklist before making a trade.

Mentioned in story

Here’s a not-so-fun fact: 70-75% of today’s retail traders lose money. That should be surprising, but it isn’t: beloved brokers like Robinhood are designed to make their customers trade frequently, even if it means making them trade badly. But if you’re wise to their games, you won’t just be among the esteemed 25%: you’ll actually be able to capitalize on everyone else’s bad habits.

How has Robinhood changed things?

Robinhood – and other neobrokers like it – wants more people to trade, and all those people to trade more. That’s what their revenue depends on – not how well those investors actually perform. And it’s figured out two ways to do it: by making trading as cheap as possible, and by making their apps simple, fun, and addictive.

The first part was easy, with Robinhood pioneering the idea of dropping the barriers to entry by introducing commission-free trades. And it worked: the number of users on the app grew from around 500,000 in 2014 to 13 million in 2020. Company after company has followed the example it set.

As for the second part, Robinhood has simplified investing massively by reducing the amount of information investors are given, and made it more dynamic by introducing features like the stock market’s “top movers” list. Some brokers like eToro have gamified the process by letting users copy popular investors, or share their P&L with their friends. All these tactics have worked well: users of new platforms trade as much as 40 times as many shares as customers of more traditional platforms.

So what’s the problem?

These new features have made investing more fun and accessible, but they certainly haven’t made the average Robinhood user a better investor.

In fact, a new study has shown that they’re more likely than other investors to make trading decisions based on “attention” i.e. how the information is presented than on critical thinking. That makes them more likely to make the following mistakes:

  • Over-concentration: Robinhood’s investors only hold three stocks on average, and 35% of its users’ net buying is concentrated on the same 10 stocks. That not only increases their exposure to company-specific risk – which could easily be diversified by simply holding more stocks – but also to the risk of suffering large losses when the crowd dumps the stock.
  • Oversimplification: Half of Robinhood’s users are first-time investors, who are less likely to have developed clear criteria regarding which stocks to buy, how much to buy, and when to sell. As a result, they’re more likely to base their decisions on simple and engaging metrics – if the stock’s in the “top mover” list, say, or if it’s recently attracted a lot of attention in the news.
  • Overtrading: As investing superstar James Rogers once said, “One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do.” Impulsive, attention-driven trades are not only unlikely to make investors rich, they might also impair their ability to differentiate between good and bad opportunities. And just because the trades are commission free doesn’t mean they’re free free: investors have to pay the bid-ask spread on every transaction.
  • Herding: The study found that so-called “herding” events – where users are more likely to buy the same stocks at the same time as other investors happen nine times a day on average. And the impact is devastating: the study showed investors underperform the S&P 500 by an average of 5% over the following 20 days. And since many of them who have bought the stock will have done so using leverage, they’ll exit the position in a deep loss. Just look at the chart below: a large positive return (green line) convinces investors to buy the stock en masse (grey bar). But by the time the majority has entered, returns become negative and most investors end up losing money on the trade.
User herding leads to negative abnormal returns. Source: Barber et al. (2020)
User herding leads to negative abnormal returns. Source: Barber et al. (2020)

How can you make sure you don’t lose money?

As Warren Buffett once said, “Rule number one is to never lose money. Rule number two is to never forget rule number one.”

Robinhood’s tricks and traps might cost you a lot of money if you’re not careful, so you’ll want to put a process in place to limit their impact. You could, for example, develop an “anti-attention” checklist, where you ask yourself the following questions before making an investment decision:

  • Does buying the stock fit my investment process?
  • Can I clearly articulate three reasons why the stock should go up?
  • Am I aware of the main three risks the stock is exposed to?
  • Would buying that stock make my portfolio more or less diversified?
  • Am I at risk of overtrading?
  • Has the stock been heavily in the news recently? Have I found it through “attention grabbing” lists like Robinhood’s “top movers”?

Simply having the checklist in place to limit the impact of your behavioural biases should already be a significant enough victory, as well as improve your chances of being in the 25% of investors who are making money. But if you’re keen to take this one step further, there is a way to spot these herding events before they arrive…

What’s the opportunity here?

More advanced investors could actually try to profit from these herding events.

By identifying which stocks are likely experiencing herding, you could short them and buy the S&P 500 as a hedge, enabling you to profit from that negative “abnormal return”. To identify those stocks, there are a few metrics you can look at: the number of Google searches, recent abnormal volume, extreme recent returns, abnormal news coverage, or recent earnings announcements.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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