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Herding by ‘Naive’ Robinhood Traders May Be Good Signal to Short

Justina Lee
·3 min read

(Bloomberg) -- From buying the dip to surfing the tech surge with options, an investor following the Robinhood crowd this year would have a lot to feel good about.

Provided they didn’t follow too long, that is.

Users of the millennial-friendly app -- the first to offer commission-free trading -- are more likely to chase popular stocks with extreme performance. The result is herding that ultimately becomes a drag on those companies’ returns, according to the latest academic research into retail investing.

When Robinhood users pile into a stock in large numbers, the average excess return on the day surges to 14%. But this is followed by a reversal of nearly 5% over the subsequent month, a new paper found.

The thinking is that in seeking to make investing easier, the platform’s slimmed-down interface could be resulting in concentrated trading in the most “attention grabbing” shares. That increases the chance of herding which can lead to big market reversals.

“Robinhood users are more subject to attention biases,” wrote authors including behavioral finance pioneer Terrance Odean. “The combination of naïve investors and the simplification of information is associated with herding episodes.”

Robinhood was at the center of Wall Street drama this year as the young fintech firm stirred up an investing frenzy amplified by Covid-19 restrictions and stimulus cash.

As retail volumes spiked, even professionals started tracking the activity of Robinhood’s 13 million users in a hunt for fresh trading signals. To do that they relied on data from Robintrack, a website that provided updates on retail stock demand, on which the academics also based their calculations.

One idea from the academic world: A strategy of selling a security after a herding event and buying it five days later delivers a 3.5% return and nearly double that for more extreme scenarios.

In fact, the researchers say there’s good reason to think hedge funds are doing some version of this, since they observed a spike in short interest among shares bought heavily by Robinhood traders.

It’s familiar territory for two of the paper’s co-authors. Odean at the University of California, Berkeley, and Brad M. Barber at the University of California, Davis have previously documented a tendency for individual investors to buy stock darlings.

In the case of Robinhood, they argue it’s even more extreme, since many users are first-time investors on a platform that offers frictionless trading and only limited information. For instance, users buy equities on the app’s “Top Mover” list more aggressively than other individual investors, meaning they’re more likely to trade extreme losers as well as winners.

“How information is displayed can both help and hurt investors,” wrote the team, which also included Xing Huang at Washington University in St. Louis and Chris Schwarz at the University of California, Irvine. “The simplified user interface influences investors decision.”

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