Democratizing Risk: Are Stocks An Instrument For Inclusion?

~6 min read

The stock market has traditionally been a province of the wealthy. Over time, financial instruments have been developed to include more investors in the markets through professionally managed risk-sharing. Today, the market is more accessible than ever, with a stable of micro- and robo-trading platforms emerging that promise to empower even the most modest of traders. Equipped with proprietary tech, market savvy, and user-friendly interfaces, these platforms want to make trading easier than ever, thereby giving the 99% the same wealth-building tools enjoyed by the rich. But with trading comes risk, and given the heightened volatility brought on by COVID-19, it is critical to consider whether stock investments are the right tool to help the less fortunate find their financial footing.

All For One

Since Mondato’s last review of the micro-investing space, a great deal has happened. The coronavirus pandemic imperiled the financial security of billions across the world. The resulting fallout sent stock markets across the world reeling, with dozens of national indices posting double-digit losses on the year. Governments, in turn, took on extraordinary amounts of debt in order to provide stimulus and loan guarantees in hopes of limiting economic carnage.

COVID-19 isn’t done with us yet, and its economic effects will not be fully clear for years. What is clear, however, is that after global markets cratered in March, most national and regional indices have begun to climb back. Despite this recent bounce, few are at pre-COVID levels, and most appear to be splitting the difference:

National Stock Indices, 12-Month Trailing View

Source: Bloomberg

It’s against this harsh backdrop that micro- and robo-investing platforms have been making waves in developed markets. U.S. brokerages like M1 Finance, WeBull, Stash, and Acorns have been ramping up operations to bring more and more users into the investing ecosystem, with the latter even introducing Acorns Early, a new product designed for parents who want to invest on behalf of their children. This industry-wide push to get more, younger investors into retail trading in the U.S. seems to be working; many U.S. brokerages have seen an uptick in new account sign-ups this year, with Robinhood leading the pack at 3 million new funded accounts so far in 2020.

If the name Robinhood rings a bell, it may be for two reasons. First, they just closed a Series F funding round to the tune of $600 million at an $8.6 billion valuation. Second, they came under intense scrutiny last month after a 20-year-old trader in suburban Chicago took his own life upon discovering a negative balance of more than $730,000 in his Robinhood app. Tragically, the young trader was mistaken, and his account was not in fact overdrawn by three-quarters of a million dollars. The shocking sum was likely the result of a complex option trade called a “put spread", in which it takes time for the full settled amount to arrive in the trader’s account. Apparently not aware of the delay, the young man thought he had thrown away his future.

Democratizing Risk

The technology powering these cutting-edge platforms may be new, but they play essentially the same role as the stock brokers of days past. They've tweaked the model somewhat, offering zero brokerage fees to traders on equities, ETFs, and options (and thereby nudging competitors to do the same) thanks to an innovative arrangement with market makers that affords firms like Robinhood an alternate revenue stream. This practice, known as "payment for order flow", brought in close to $100 million in revenue for Robinhood in the first quarter of 2020 alone; their competitors have also pulled in hundreds of millions thanks to the practice. Put simply, these firms sell users' trades to other companies, who then reward them with a few pennies per trade. Traders get better prices; the platforms make a killing; and so do the market makers. Everyone wins, right?

Researchers have pointed out that this business model rewards risky, high-frequency trading, and indeed this may be part of the magic formula for firms like Robinhood, whose users traded up to 88 times as many options contracts as users of competing platforms (per dollar in the average customer account) in Q1 2020:

Source: New York Times

The same research revealed that Robinhood made $18,955 per dollar in the average customer account by way of "payment for order flow" during this period, which was up to 10x as much as competing firms. This may be due to Robinhood's DNA, which is more Silicon Valley than Wall Street. According to reporting by the New York Times, the firm is adept at building "behavioral nudges and push notifications" into its platform, which encourages users to trade at higher frequency, whether they're doing it as part of a broader trading strategy or not.

Important questions arise, then, about the responsibility shouldered by these innovative trading platforms (and traditional brokerages, too) within the context of the financial health of society. The notion of "democratizing investing" urges that investing should be accessible, with traders from all socioeconomic backgrounds able to participate in the long-term wealth-building that can result from the stock market. But with trading comes risk. Investment platforms who turn a profit by encouraging nonstop, risky trading may in fact be democratizing the worst aspects of market participation -- at a time when the economic effects of COVID-19 could lead to a prolonged economic downturn and financial hardship for many.

Passive Beats Massive

Certainly, investment should be accessible. The freedom to participate in the stock market -- under the right circumstances and with the right protections in place -- is the freedom to build wealth. Ideally, Fintech should be an ally of the many in this endeavor, enabling newcomers to invest responsibly and thereby building more inclusive markets.

Many Fintech firms are aware of this awesome responsibility. Robinhood, in light of the recent turbulence, have pledged to alter their user interface and offer more educational resources while possibly upping the criteria for complex options authorization.

Other firms take a different approach to the question of democratization. Ualet, the Colombia-based robo-trading platform, emphasizes a lower-risk, highly diversified strategy for less-experienced investors, according to CEO Leopoldo Forero:

In our case we target retail investors with low knowledge and low risk tolerance; we are committed to giving access to the best investment and the best advice, with diversified low risk and low cost approach. Other approaches, where clients are encouraged to do frequent trades or leverage their positions (via CFD or other more advanced derivatives or financial products) play and will continue to play a role, but it's just not the direction we would like to take our clients. Our direction is about setting up tools and ease of use to make investments more profitable and more readily available to fulfill goals.
Leopoldo Forero, CEO, Ualet

Passive robo advisory services (of the kind offered by Ualet) create returns for users without requiring input or active trading; they enable participation in the stock market while excising the risk inherent in trading sophisticated options with little experience. Of course, there is still risk in the markets, as we've been reminded by the global shock of COVID-19. At the height of the crisis in Colombia March, Ualet took steps to fulfill their obligations to investors, while also managing the (understandable) jitters of users who were new to the markets:

We made important efforts in terms of automation and putting in place our own resources to accelerate cash-outs at the same time that we explained to clients the setbacks of taking withdrawals amid a drop in asset value. We had to educate our clients in that the loss is only materialized once they liquidate their position. Having a medium- and long-term mindset is an important investor virtue.
Leopoldo Forero, CEO, Ualet

A medium- or long-term mindset may not be compatible with every individual trading strategy, but it's essential for a healthy market. When traders panic and cash out en masse in response to a crisis, or try to "time the market", they tend to lose more often than if they had simply stayed the course, exacerbating the market crash. In fact, if the ultimate objective is to help more people build wealth, passive investing may be a better answer than democratization by app. Studies have repeatedly shown that, over time, passive investing tends to beat active -- and that is even without the help of robo-advisors.

Democratizing investing is just one of the ways that Fintech firms can create opportunities for financial inclusion. However, actively trading stocks and options can lead to losses just as quickly as gains, particularly during volatile times. For this reason, new investors must be brought onboard with care. Adequate investor education and control of risk is sure to pay dividends later, as investors who make gains in the market are obviously more likely to stick around and reinvest relative to those who make losses. If there are more surprises in store for the second half of 2020, at least one positive fact remains: new traders are joining the market every day, and all else equal, that's a good thing.

© Mondato 2020

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Mondato is a boutique management consulting firm specializing in strategic, commercial and operational support for the Digital Finance & Commerce (DFC) industry.
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