Behavioral finance has been a warm topic of conversation well into 2022, as the U.S. Securities and Exchange Commission (SEC) is starting to scrutinize commission-free brokers and trading platforms for its use of behavioral social prompts that can be misleading for intraday novice traders.
It’s been just over a year since the GameStop (NYSE:GME) "meme stock" frenzy, which saw the company’s stock prices surge by more than 1,500% in January 2021. The rally prompted a "short squeeze" in the market, putting hedge funds that had bet against the stocks at risk, increasing market volatility.
As intraday traders and retail investors are growing by the masses, with more trading apps and commission-free investment platforms coming to life, companies are feeding small-time investors an opportunity to enter the stock and investing market, without having to deal with brokers and high trading fees.
Earlier this year, SEC Chair Gary Gensler shared a stark warning to the growing population of small-time investors, stating that:
"Statistics usually show that investing is good, but trading often is not."
The record number of new trading apps and those who frequently use them have gained quite the amount of media attention. In a Feb. 16 interview, 98-year-old investor, Charlie Munger shared a prejudiced view on the rising amount of new trading platforms and intraday traders, claiming it’s become "an ideal gambling parlor activity."
Even with growing skepticism, behavioral finance, and social prompts, statistics from 2020 indicate that more than half of financial advisors across the world found that using behavioral finance has helped keep retail traders invested as market volatility increased.
Behavioral Finance In Action
As small-time traders and younger investors start to better understand the financial aspect of intraday trading, critique over the somewhat worrying situation has placed popular trading platforms such as Robinhood (NASDAQ:HOOD), eToro, and Trading212 under public scrutiny.
An academic research study found that behavioral finance is the understanding of how people make financial trading and investing decisions based on cognitive errors and emotional biases that can impact the stock market in a variety of ways.
The study claims that behavioral finance can challenge the assumption of traditional finance—meaning that retail and intraday investors are making investment decisions not based on a rational manner, but rather irrational and an unbiased approach.
With the growing demand for more open market strategies, and the democratization of the stock market, behavioral finance has impacted the stock market in some of the following ways:
Gambler's Fallacy—investors make inappropriate decisions and tend to reverse their investments, not holding on to them for long enough to grow. This, on the other hand, means that short squeeze stocks are becoming more prevalent in the current market.
Biased towards current availability—novice and small-time investors are finding it easier to invest in stocks and securities that are currently trending, which in return leads to less growth and poorer returns for both the investor and the securities.
Overconfidence—while confidence can be the key to success, younger traders who are confident about their initial investment will stay with it for shorter periods, while traditional investors are more rational, making decisions based on analytics and investment trends.
Market Sentiment—this is more directed to the overall feeling or emotion conveyed by the market as a whole. When stocks are falling, investor sentiment will decrease, in return, behavioral finance and the impact thereof on small-time investors can leave them with a feeling of disbelief and greed.
How can small-time investors curb losses? While there’s a lot of intrigue around the topic of behavioral finance and how it’s currently impacting younger traders and the stock market as a whole, there are growing efforts that support the improvement and education for small-time traders.
A 2021 BBC interview with chief executive Adam Dodds of Freetrade found that more than 60% of onboarding subscribers in 2021 claimed to be first-time investors. The customer base jumped from 50,000 in January 2020, to more than 700,000 by December 2021.
Dodds explains that even with the rise of free trading platforms and apps, it’s becoming clear that younger generations are looking for easier, and more affordable ways to get into the stock market.
With the growing number of interest, how can novice, first-time investors ensure better returns, and understanding of the stock market?
In a January 2022 Forbes Advisory review, experts suggest that new investors should consider their finances, and how much money they’re allocating towards trading and investments.
Expert investor Warren Buffet prompted that new traders should avoid stock picking. Start by purchasing index funds, such as the SPDR® S&P 500 (NYSE:SPY), and hold your position for as long as possible. Buffet explains that when an investor purchases an index fund, it gives them a better opportunity to grow their passive income strategy, without needing to stock pick.
When purchasing stocks or trading for the first time, it’s become quite clear that new traders are good at picking the wrong stocks, thinking they will grow in the future. This not only leads to financial losses, but also decreases the value of your portfolio.
A study published by the SEC found that a lack of financial literacy and the stock market saw new investors picking underperforming stocks, as opposed to their stronger, more educated counterparts. Additionally, the study mentioned how financial illiteracy can cause younger generations to not invest in the stock market at all.
Financial illiteracy has become one of the biggest challenges for free-trading apps and platforms, and so it’s suggested that new traders and investors consider developing a trading strategy that will work to grow their portfolio, and ensure better market observation.
As you learn more, you can start looking at different indexes, and investment opportunities, from forex to crypto and NFTs.
There’s a growing notion that investments and trades are a "get rich quick" situation, when in fact, it’s the complete opposite. Investing in the stock market requires a lot of time and patience and experts suggest that new traders should hold on to their investments. So what’s in store for the future?
As more and more traders are coming into the market, it’s clear that the demand for trading apps will only increase in the coming years. While these platforms have enabled more access and transparency in the market, allowing younger generations to become accustomed to investment opportunities, it’s also left the market with a higher chance of volatility.
Government regulators such as the SEC are trying to intervene, looking to establish progressive protocols for brokerage trading apps, but the extent thereof has yet to be fully implemented.
Digital trading engagements, such as behavioral social prompts, and on-app notifications, are becoming a common trait, which enables users to quickly and easily do trades. Even as these platforms progress, small-time traders should consider the risk involved with trading and investing in the stock market.
For now, experts suggest that education, and holding on to an index fund or investment for as long as possible will be the only way newcomers will be able to see actual improvements in their portfolios.