Uh oh; here we go again. In January, equity prices for companies such as GameStop gyrated wildly, amid frantic retail trading on digital platforms such as Robinhood. Cue hand-wringing from mainstream players — and stern congressional hearings.
Volatility abated. But now it is erupting again: on Wednesday, the price of GameStop surged to $348.40, then crashed to $200, in a frenzy that turned the tiddler into one of the most heavily traded stocks on exchanges. The equity price of Koss (maker of headphones) and AMC cinema group also swung, as did those of Tesla and bitcoin.
What should staid investors make of this? One obvious lesson is that it is a mistake to assume that online retail trading dramas have been halted by congressional hearings. The analyst Larry Tabb told the FT that retail trading has accounted for as much activity as mutual funds and hedge funds combined in the last year.
This might decline after the pandemic. After all, as Richard Thaler, the behavioural economist says, the boredom of lockdown and rising availability of trading apps has probably intensified interest among millennials.
However, a cessation cannot be assumed anytime soon. A survey by Deutsche Bank suggests that half of investors aged 25-34 with a brokerage account will put half of whatever they receive from Joe Biden’s upcoming $1.9tn stimulus package in the stock market. Deutsche thinks this could generate $170bn of new inflows.
That is remarkable. And it underscores a second lesson from this week’s market swings — the need for investors to reread the 2011 book Thinking, Fast and Slow by the psychologist Daniel Kahneman. It identifies two main modes of human thought: “system 1”, or “fast” thinking, occurs when humans make “intuitive” decisions based on their gut reaction to whatever grabs their attention and emotions; and “system 2”, or “slow” thought, which involves considered analysis of a range of visible and less-visible data with less emotion.
When Kahneman’s tome first emerged after the 2008 crisis, many mainstream investors hailed it as a self-help guide — and pledged to avoid too much “fast” thinking, or emotional bias, in their strategies.
However, this fast/slow dichotomy now has a new twist. One way to frame recent events is as a tussle between mainstream investors who are trying to think “slow”, and a retail crowd defiantly acting “fast”. This does not mean that mainstream investors do not respond to emotional cues or only act in a “rational” way. (Anyone buying Treasuries today, say, may look irrational in the future.) But the key point is this: the “fast” thinking crowd is not behaving within the cognitive frame that “slow” investors expect.
This is described well by the academics Brad Barber and colleagues. They point out that the design of online platforms like Robinhood foster ultra “fast” thinking. “The simplification of information on the Robinhood app is likely to provide cognitive ease to investors, leading them to rely more . . . on system 1 thinking and less on system 2,” the paper says, noting that “Robinhood only provides five charting indicators [for evaluation], while [online trading platform] TD Ameritrade provides 489.”
As Kahneman tells me: “Anything that speeds people up instead of slowing them down is going to cause more impulsive and uncritical behaviour.” This creates distinctive patterns. “Fast” thinking investors on trading apps chase stocks that have posted abnormally high gains and losses, unlike more mainstream investors. There is extreme herding around a small group of names that retail traders either know from their own consumption habits (such as GameStop) or from the news. A separate paper by academics Gideon Ozik, Ronnie Sadka and Siyi Shen, determines that in 2020 trading frenzies typically erupted “among stocks with high Covid-19-related media coverage”.
What drives “fast” thinking in finance, in other words, is not just emotion but attention. Or to cite Kahneman again: “The notion of ‘attention trading’ is a very productive way to explain behaviour.”
This often results in losses. The paper by Barber et al calculates that “the top 0.5% of stocks bought every day lose about 4.7% over the subsequent month”. Greg Davies, head of the Oxford Risk behavioural finance group, thinks “emotional” trading typically costs investors three percentage points of annual returns, but is losing them more now. “We currently have the perfect storm for emotional investing,” he argues. The pandemic means many investors are “highly emotionally sensitive and have a shortened emotional time horizon which increases the appeal of get-rich-quick gambles”.
Therein lies a tragedy, not least because savvy players are undoubtedly feeding off retail players “fast” thinking mistakes. But there is a wider lesson here, too: if you want to understand share prices today, look beyond valuation models or trading algorithms.
Attention matters deeply, now. So does emotion, particularly since spring weather (in the northern hemisphere) could soon blend with lockdown relief and that $1.9tn American stimulus package, which some recipients may yet use in ways that Biden may never have expected — or wanted.