Individual investors may be about to lose prodigious amounts of money during the COVID-19 pandemic—but it’s not simply due to the overall market drop over the past two months.
A confluence of factors has come together to bring about some of the worst and most value-destroying behavior by individual investors, also known as retail investors, in history. Newly granted access to high-risk markets, the appearance of zero-cost investing, historic levels of credit extended to nonprofessional traders, and an absence of other outlets for risk-taking behavior have all combined to produce a situation where many retail investors are losing money hand over fist in volatile and opaque markets they don’t fully understand.
We are beginning to see this destructive behavior play out in the data. For futures markets, something normally only accessed until recently by institutional investors, we have seen average daily volume in overnight trading nearly double in the first three months of 2020 for the E-mini S&P 500 futures contract (a security specially designed to attract retail investors due to its lower cost than the total S&P 500 contract). In the equally high-risk options markets, average monthly trading volumes jumped 58% between January and March of this year.
While this is worrisome for the average investor’s portfolio, the news in the U.S. stock market is even worse—namely the severe jump in retail investors short selling, a bet against the market where losses for investors are potentially unlimited. As equities of U.S. companies with high market capitalization (also known as large-cap stocks) bottomed out on March 23, short interest on the SPY (another favorite of retail traders that tracks the S&P 500) sat at $50 billion. Short interest expanded over the next three weeks to $66 billion, but at the same time U.S. large-cap stock rebounded almost 25%. This implies that an additional $4 billion was lost over that period as retail investors rushed to short the position.
How did retail investors gain such broad access to these markets and begin to make such bold bets? Much of this can be traced back to the proliferation of what are widely known as zero-cost trading platforms, which allow individual investors to purchase funds with no fees. Over the past two years, the rise of services like Robinhood has forced traditional players like E*Trade and Fidelity to offer similar plans.
In addition to zero-cost trades, many of these startup trading platforms offer individual investors higher-than-normal amounts of margin (loans for investing) while requiring little money down, as well as easy access to high-risk options and futures markets. These companies’ apps make trading in these markets as easy as one or two taps on a phone—you can place $100,000 in trades instantly with a balance of just $10,000.
The problem here, aside from the risk taking, is what the investor believes are the costs of trading in these new markets. Unlike traditional investing in stock markets where the costs to trade are explicit (for example, a flat fee per trade placed), in options and other derivative markets the true costs are implicit and hidden to the average investor in things such as the bid-ask spread—something most retail investors don’t factor into their decision making. So even if the explicit costs to trade are zero, investors can lose 10% or more of their investment in implied costs every time they trade a derivative.
The coronavirus crisis has forced most white-collar employees to work from home, leaving many with no outlet for the small pleasures they used to enjoy in everyday life, such as group sports activities, going out for drinks, or betting on sports. Reddit is filled with tales of some investor turning a small investment into a million-dollar gain overnight. This gives that homebound, bored retail investor some hope that they can do it too. Yet the truth is that the more “zero-cost” trades the investor places in these markets, the more fees they rack up and the more they destroy their long-term investments.
It is a scary time for those who have watched the stock market plunge this year, but retail investors need to resist the allure of trading in derivatives markets as a way to make up for portfolio losses. Now more than ever, individual investors need to remember the basics of Finance 101: minimizing costs and resisting the urge to try to time the market is the best thing one can do for their portfolio’s future.