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Robinhood-focused dopamine trade raises adequacy issues for SEC

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Some investors have learned the hard way that trading securities on the Robinhood platform is not for them; and the Securities and Exchange Commission (SEC) is now focusing his attention on the practices of Robinhoods and business model. As the SEC begins its initiative in this regard, it is important to understand how the concept of relevance applies to investors’ trading on Robinhood, and how to form an opinion on the extent to which platforms like Robinhood are suitable, or not, for different types of investors. In this article, I will offer some ideas and statistics to examine this question.

Adequacy was introduced into the regulation of the US financial markets in 1934, after the manipulative practices of brokers in the run-up to the stock market crash of 1929 led many investors to take risks they did not understand and which, unsurprisingly, were inappropriate for their situation.

It is increasingly evident that for many investors trading on Robinhood is totally unsuitable. At the top of my list are investors who suffer from gambling addiction. In 2013, the American Psychiatric Association reclassified problem gambling behavior from an impulse control disorder, such as kleptomania, to an addiction and substance abuse disorder, such as those associated with alcohol and drugs. Ironically, Robinhood was founded in 2013, the same year that pathological gambling was reclassified.

Gambling addiction is linked to dopamine and is part of the phenomenon author Anna Lembke calls Dopamine Nation, the title of his new bestseller. Lembke describes how addictions arise from pleasure-seeking people, where feelings of pleasure involve dopamine flows rising above the baseline.

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Studies show that people who suffer from gambling addiction differ from others in at least two ways. First, gambling addicts have a harder time generating dopaminergic effects. Therefore, they need more powerful stimuli than others to induce the same types of euphoria. Second, compared to others, the executive part of the brain of drug addicts is weaker, causing them to experience greater difficulty in controlling themselves. Taking these two characteristics together means that gambling addicts have to take more risks to reach the same psychological heights as others, and are more inclined to do so, even though they know they may behave recklessly. .

The Robinhood platform does a superb job of generating stimuli that activate dopamine-based reward centers in the brains of its users. It can be akin to giving a baby candy, and for game addicts it can be akin to providing them with enough rope to hang themselves on. Research suggests that part of the brain connected to vision plays an important role in regulating the level of risk sought by people, presumably by impacting dopamine flows in regions of the brain associated with anticipation.

According to the North American Foundation for Gambling Addiction Help, the percentage of the American population who suffer from gambling addiction is around 2.6%. In my own research on online trading behavior, carried out with financial economist Arvid Hoffmann, we find that the percentage of investors who behave as if they are addicted to gambling is around 2.5%, so practically the same.

Investors looking for high risk bets often trade options. The New York Times
NYT cites a study by the company Alphacution which found that investors using the Robinhood platform traded 88 times more options contracts than investors using the rival Schwab platform, compared to the average account size. In this regard, the CEO of Robinhoods told the Times that 12% of investors who actively trade on the Robinhoods platform each month trade options.

In the data Hoffmann and I use, 20% of investors actively trade options and 12.5% ​​state that speculation is their main motive for trading. The intersection, investors whose primary motivation for trading is speculation, and who use options to do so, comprises about 5% of our data sample. This group has a terrible investment performance, earning an average of 27% less per year than investors who are not speculators, which of course means incurring significant losses.

A key point made in the New York Times Robinhood’s coverage is that many of its users lack investment expertise. My research with Arvid Hoffmann suggests that a little knowledge can be a dangerous thing. Specifically, the worst performing group of investors is the one who, in addition to trading options and having speculation as their primary investment objective, also uses technical analysis. This group earns an average of 43% less per year than investors who do not trade options, do not have speculation as their primary focus, and do not use technical analysis. This is the group whose behavior is most consistent with gambling addiction, and again accounts for about 2.5% of our data sample.

As for which investors the Robinhood platform might be suitable for, think about investors who trade for entertainment, and do so with prudent risk and discipline. In the data underlying my work with Arvid Hoffmann, around 25% of investors have entertainment as their primary motivation for online trading. Just to put the key issue in context: Investors who use options and technical analysis, and who identify an objective other than speculation as their main motivation for trading earn on average 73% more per year, adjusted for risk. , than their speculative counterparts. There are plausible grounds to argue that the Robinhood platform could be suitable for investors looking for entertainment.

About 63% of investors in our data say they have goals other than entertainment and gambling for e-commerce. Around 44% say capital growth is their primary goal, and around 12% say they build up a financial reserve for the future. Others report saving for retirement as their main goal.

The adequacy issues for the 63% just described seem subtle to me. Additionally, dopamine is an issue here, but in a different way than discussed above. Investment strategies for successful long-term wealth creation are generally different from strategies designed for short-term horizons.

Investing for the long term is less about thrill-seeking, stock picking, and market timing, rather than optimizing mean-variance. Means-variance optimization is largely a boring exercise for most investors, which means low dopamine flows most of the time.

Investors may know they need to focus on building long-term wealth. However, they may not know how to build and implement such a strategy on their own. If they are overconfident in their abilities, and trust their intuition, their pleasure-seeking instinct might prompt them to implement strategies, on a platform like Robinhood, that are poorly designed to build wealth in the long run. term. Interesting recent work from behavioral economists reveals that investors using the Robinhood platform are engaging in more attention-induced trading as retail investors using other platforms; and nothing grabs the attention of investors more than the anticipation of a dopamine surge.

A key finding from the behavioral finance literature is that the more the individual investor trades, the more worse on average is their performance. A key part of this conclusion is that increased trade leads to higher transaction costs. This feature also applies to trading on Robinhood, which claims to offer commission-free trading. However, the claim about commission-free trading seems like a framing exercise to me, as the brokers who actually execute trades on the Robinhoods platform pay for the flow of orders. As a result, there is reason to believe that traders on the Robinhood platform might not benefit from best execution and therefore incur transaction costs indirectly rather than directly.

The late John Bogle made it his life mission at Vanguard to make it easy for investors to choose strategies that are in fact well suited to creating long-term value. These long term strategies are almost as easy to implement as trading on the Robinhood platform. The point is, the long-term value creation approach does not produce the same dopamine surges that are produced from trading on the Robinhood platform. This phenomenon is also part of Dopamine Nation syndrome.

Sources

1/ https://Google.com/

2/ https://www.forbes.com/sites/hershshefrin/2021/09/11/dopamine-driven-trading-on-robinhood-raises-suitability-issues-for-the-sec/

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