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The Dark Side of Financial Technology Tools

Do ‘digital engagement practices’ actually benefit investors?

Financial technology firms tout that they have brought Wall Street’s investment tools to Main Street, empowering retail investors to compete with professionals.

However, research, including a series of papers by Brad Barber and Terrance Odean, has demonstrated that retail investors are susceptible to behavioral biases and often chase attention-grabbing stocks and severely underperform the market because of active trading. Further research shows that the uninformed “noise trading” of retail investors can lead to mispricing, especially for hard-to-arbitrage stocks and during periods of high investor sentiment. Which begs the question: Do these ‘digital engagement practices’ benefit investors, or do they benefit the providers by leading retail investors to become overconfident and engage in destructive behaviors such as excessive and risky (gambling-like) trading?  

Che-Wei Liu, Yanzhen Chen and Ming-Hui Wen, authors of the June 2023 study Alert for Alerts: How Investment Price Tracking Alerts Affect Retail Investors, sought the answer to that question by examining price tracking alert tools’ impact on the performance of retail investors. They began by noting: “FinTech does not necessarily rectify investor biases and may even amplify them, especially for those with limited financial literacy. In fact, the most frequently asked question by retail investors who use Robinhood, a commission-free trading platform that attracts millions of retail investors, is ‘what is the stock market?’ Consequently, technologies accessible to amateur traders may be ineffective or even counterproductive.”

The authors partnered with one of the largest retail mutual fund investment platforms in Taiwan—one that provides a free price tracking alerts tool. The database included more than 20,000 retail investors’ detailed trading data and performance. Their control group consisted of investors who never adopted the price tracking alerts, while the treatment group consisted of 932 investors (approximately 4.5%) who utilized the alerts feature. The data covered the period January 2017-June 2020. Here is a summary of their key findings:

Adopting an alert reduced investment performance by about 2% a year, confirming the literature—attention-included trading tends to be followed by negative abnormal returns. Adopters tended to be speculators—investors who redeemed investments more quickly and demonstrated a higher tolerance for loss were more inclined to adopt alerts.

Age was the primary demographic factor that led to adoption, although effects diminished among older investors. Middle-aged investors primarily composed the group opting to automate portfolio management using price tracking alerts. Gender also seemingly had an impact, as female investors exhibited a relatively higher preference for alerts.

The observed detrimental effect on investment performance may have been attributed to a lack of pricing skills and a tendency toward excessive trading. Investors with insufficient financial knowledge (high superstition, inexperience or investment without nonspeculative objectives) suffered more from the unintended consequences of adopting the feature.

The results dovetailed with the investor overconfidence bias literature and showed that performance deteriorated more when tracking unfamiliar funds and engaging more with active trading strategies.

Their findings are consistent with those of Qiqi Liang, Mohammad Najand, David Selover and Licheng Sun, authors of the December 2022 study Retail Trading around Earnings Announcements: Evidence from Robinhood Traders. Examining the retail trading activities around the earnings announcements with data from the U.S. online discount broker Robinhood, they found that Robinhood traders swarmed into stocks with pending earnings announcements and lost interest in them immediately after the announcements. There was a surge in buying starting from about four days prior to earnings announcement. However, the buying peaked exactly on the announcement date and then quickly fizzled out after the announcement.

Unfortunately, they also found that Robinhood investors, on average, lost money after the earning announcements, with negative average returns immediately after the announcements; and the negative returns persisted even after two weeks. The authors concluded that there is “significant and consistent evidence that suggests investor attention acts as the main driving factor that motivates Robinhood investors’ trading around earning announcement dates.”

Investor Takeaways

The empirical evidence demonstrates that there is a dark side to financial technology tools that give easy access to information and lower monitoring costs for retail investors. While they improve the information environment, they also cause investors to falsely believe they have better control over their portfolios and/or superior knowledge of the market. The tools can also exacerbate the cognitive biases of retail investors, creating a false sense of urgency and pressure to trade, resulting in increased trading and gambling-like behaviors, both of which lead to underperformance.

A growing body of research suggests that investment alerts do not produce more informed retail investors overall. For example, Jesse Glaze, author of the June 2022 study Fast-Thinking Attention and the Disposition Effect, found that while Robinhood’s push notifications helped investors pay more attention to their portfolios and to the markets, they also caused investors to make “worse decisions than if investors paid no attention at all.”

Larry Swedroe has authored or co-authored 18 books on investing. His latest is Your Essential Guide to Sustainable Investing. All opinions expressed are solely his opinions and do not reflect the opinions of Buckingham Strategic Wealth or its affiliates. This information is provided for general information purposes only and should not be construed as financial, tax or legal advice. 

TAGS: Equities
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