The Growing Role of Retail Investors in Stock Market’s Volatility

2020 will forever remain in history as the year when the COVID-19 pandemic started. With it, the world changed in unthinkable ways, and financial markets reacted accordingly. 

For the first time ever, advanced economies used helicopter money to support the economic recovery. More precisely, the U.S. government sent checks to Americans with the hope that most of the sum will end up spent in the economy. Judging by last month’s retail sales, which grew by the fastest pace since 2011, the program worked. Yet, a big part of the stimulus ended up in the stock market, with retail trading activity increasing spectacularly.

Herding Leads to Investment Bubbles

Robin Hood, a broker in the United States known for offering fractional share investing as well as options trading, saw its app downloaded hundreds of thousands of times/month. As retail investors got an interest in the stock market, they populated trading rooms, chats, forums in search of tips for good investments.

Companies popular among millennials had one of their best years ever. Think of Tesla, that continued to rise despite a stock split and returned over 600% to investors in 2020 alone.

Behavioral finance has a fancy name for traders acting at unison – herding. When in January this year, retail traders acted in unison and bought shares and call options on GameStop, a troubled company known for being heavily shorted, the short-squeeze that followed almost triggered the bankruptcy of some brokerage houses.

The share price of GameStop climbed dramatically to levels that made no sense when compared to financials. Herding is known as leading to investment bubbles, and, ultimately, investors lose money when bubbles burst. So it was the case with GameStop, as most of the retail investors took losses despite the market’s short-squeeze.

The event, while isolated, reveals the power the retail investors have if they act as one. Unfortunately, coordinating such actions is both difficult and in the “grey” area as regulators constantly check for market manipulation evidence. Yet, what retail investors showed is that their role on Wall Street grows considerably and will continue on the same trajectory.

Bull markets attract a lot of interest, and the laws in the United States regarding taxation and capital gains are meant to discourage speculation. After the GameStop bubble burst, the question is if herding is seen on other markets/sectors as well? Think of Bitcoin, Tesla, or the U.S. tech sector, and you’ll have an idea why regulators constantly warn of price corrections.