are retail investors even playing to win?

The COVID-19 pandemic has led to a dramatic surge in “mum and dad” retail investors playing stock exchanges across the world.

In Australia, retail investors were net buyers of A$9 billion of Australian stocks between late February and mid-May, according to corporate advisory firm Vesparum Capital. In contrast, the professional institutional investors – superannuation funds and the like – were net sellers of A$11 billion of stock.

The amateurs are therefore likely responsible for most of the market’s rebound since its March 23 low.

An Australian Securities and Investments Commission analysis of retail investor trading shows from February 24 (the day after the market peaked) to April 3, retail investors’ daily buying and selling of stocks was double that of the months before (A$3.3 billion to A$1.6 billion). More than 20% of that activity was from new or reactivated accounts.

The securities regulator has expressed concern this rush of amateurs into the stock market is a train wreck waiting to happen. Its report notes retail investors are, on average, “not proficient” at predicting short-term market movements.

While markets generally recover over the long run and tend to grow with economic fundamentals, short-term trading and poor market timing can be a major risk for investors in volatile markets. Therefore, retail investors should be wary of trying to “play the market” for short-term price movements by day trading.

COVID and risky behaviour

There are several possible explanations for why people are taking a risk on the stock market.

Some might see this as an opportunity to get into the market at a low point, with a view to long-term gains. Others might be out of work and looking to “day trade” - buying and selling shares on short time frames – as a source of income. Yet others may be taking the opportunity of working from home to watch the market through the day.

But another explanation is also worth considering. This is an alternative to gambling. So while it’s risky, it’s arguably no riskier than sports betting, casinos or poker machines.

Read more: Why stocks are soaring even as coronavirus cases surge, at least 20 million remain unemployed and the US sinks into recession

Risk tolerance

This theory (that this is gambling by another means) explains why the appetite for risk among retail investors has ballooned when the natural response to severe economic uncertainty would be to reduce trading.

The financial risk individuals are happy to tolerate – known as financial risk tolerance – is mostly determined by personality. A person’s risk appetite is unlikely to change substantially over their life, even with changing economic conditions.

Most people, however, are adept at making different risk decisions with money allocated to different “accounts”. In behavioural finance this is known as “mental accounting”.

How they think about and use their different accounts isn’t necessarily “rational”. For example, someone might be very prudent with money from their regular budget account while spending frivolously from a discretionary account.

So extreme risk-taking can occur when opportunities arise despite a person generally being risk-averse.