The Revolution That Wasn’t

Published on December 14, 2021

History does not repeat exactly, but it sometimes does rhyme. Those of us who recall the dot com bubble and the years leading up to the global financial crisis of 2008-09 often look at the crazy things that have been happening over the past couple of pandemic-stricken years and make comparisons to past episodes of market insanity. The reason history can seem to rhyme is that human nature does not change very much over time. The specific examples of fear and greed operating on asset prices are always different but the underlying psychology manifesting in crazy behavior is hardwired.

The story of Robin Hood dates back centuries, and everyone knows about how this legendary character stole from the rich to give to the poor. Robinhood, the company, released its trading app in 2015 with a stated mission of providing “everyone with access to the financial markets, not just the wealthy”. Through its free trading app and the ability to trade tiny fractions of a share of stock, along with easy access to margin, Robinhood indeed revolutionized investing, or more accurately, speculating. But as anyone even mildly familiar with history knows, not all revolutions are for the good and plenty have ended in tears.

What happens when a pandemic forces offices and businesses to suddenly close and stay-at-home orders short-circuit normal social interactions? Thankfully, the internet made it possible for many people to work from home, but 24/7 connectivity also served as a source of entertainment for millions of stressed-out people. While government stimulus checks were no doubt a lifeline for essential purchases, the infusion of funds extended far beyond the truly poor and gave bored people seed capital to be used for gambling purposes. With sporting events cancelled, the great casino known as Wall Street served as a surrogate.

The story of a period of unprecedented speculative excess is the subject of The Revolution That Wasn’t, a new book by Spencer Jakab, editor of The Wall Street Journal’s Heard on the Street column. Jakab tells the story of Robinhood, GameStop, AMC, and other meme stocks (also known as “stonks”) by examining the motivations of the individuals involved, the economics that make “free” trading possible, and the technical details behind the market gyrations. The book, which will be released on January 25, is essential reading for anyone who wants to make sense of the GameStop saga, especially the story of Keith Gill who at one point had made over $50 million on the stock. Although Gill was originally motivated by conviction derived from fundamental analysis, many of the speculators on Reddit were more motivated by “sticking it to the man” — meaning Wall Street billionaires and others who had short positions in GameStop.

The very notion of a buying stock more out of a motivation to harm short sellers than to actually make money is something that I found truly baffling when the crazy GameStop situation unfolded in early 2021. Speculators and investors have little in common in terms of how they operate but I’ve always regarded the ultimate goal of actually making money to be an area of common ground. However, as Jakab documents in some detail, a group of individuals congregating on the wallstreetbets subreddit were so enthralled with the idea of costing billionaires money that they often put that goal above a simple profit motive. Make no mistake about it, individuals such as Keith Gill who made a killing on the stock were revered among the wallstreetbets crowd, but the ability to have “diamond hands” and to keep buying to squeeze the shorts was clearly the paramount objective for many in the community. Solidarity with the goal of screwing over the shorts was the governing ethos of wallstreetbets.

Although I have a theoretical understanding of shorting stocks and the mechanics of derivatives such as stock options, I have never shorted a stock or purchased or sold an option in my life. The potential risk of unlimited losses and my distaste for misery has kept me on the long side and options have never appealed to me. In Chapter 9, Jakab does an excellent job of providing the background needed to understand what the wallstreetbets crowd was doing and how they created a feedback loop that resulted in GameStop’s stock rising into the sky like one of Elon Musk’s rockets. Jakab explains how options acted as a “force multiplier” when it came to exacerbating the short squeeze. If you aren’t familiar with what a gamma squeeze is and how this poured fuel on the fire, you’ll want to read this chapter to find out.

As a long-term investor who has traded less frequently over the years, I consider myself resilient to the worst elements of market psychology, but certainly short of immune. I did not freak out in March 2020 when the pandemic rattled financial markets and I did not grow euphoric in the surprisingly strong bull market that followed. Other than for entertainment purposes, I tune out most news stories about people doing crazy things, but in 2020, I did get curious enough about the Robinhood trading platform to open an account.

Using the Robinhood app was an eye-opening experience. I received a “free stock” which was worth about $5. To test the trading platform, I sold that stock and used the proceeds to purchase Bitcoin which I parlayed into $6.22 before closing my account in disgust. Everything from the confetti showing up after you place a trade, which has since been discontinued, to the promotion of margin trading and the ease of gambling with options militates against every sound principle of investing that I know of. And the results can be far more tragic than losing money: the platform showed highly misleading information to a twenty-year-old trader indicating that he had a negative $730,000 balance. After failing to reach Robinhood’s customer service, the young man committed suicide. Robinhood has since settled a lawsuit with the family.

How does Robinhood and other brokerage firms offer “free” commissions to customers? Brokerages receive compensation called payment for order flow in exchange for directing orders for execution. This practice is controversial because of potential conflicts of interest but it is not obvious that this practice itself harms customers. The real harm stems from the frenetic trading that occurs when transaction activity appears to be costless. Jakab cites a study that found that members of Generation Z open their trading apps 8.2 times a day and traded 147 times per year on average!

With that amount of frenetic trading and human psychology leading people to be fearful and greedy at exactly the wrong times, the decline in visible costs such as commissions pale in comparison to the penalty investors, in aggregate, suffer in the form of lower returns. The vast majority of individual investors cannot hope to beat passive index funds by picking stocks even if they follow a calm and rational approach. In my opinion, the individual investor’s edge is almost entirely a function of timeframe arbitrage — the ability of individuals who are accountable to no one other than themselves to look past the transitory headlines of the day and hold quality companies for years or decades. This advantage vanishes when individuals trade frequently.

The book concludes with a well thought out chapter offering some practical steps individuals can take to benefit from plummeting costs. It is now possible for individual investors to match the overall stock market using index funds or ETFs that charge just a few basis points per year. As Jakab notes, the only certainty with funds is their cost. He also makes a point that the YOLO (“you only live once”) crowd doesn’t seem to get: Losing money early in life can hurt badly. While taking risks when you are young enough to recover can make some sense, I don’t think that enough young people understand that gambling with a $1,200 stimulus check instead of investing it could cost them multiples of that amount in opportunity cost down the road.

Jakab concludes by pointing out that Wall Street isn’t evil or all-powerful. Armed with some basic knowledge and emotional control, there is no reason why individuals cannot greatly benefit from the revolution of lower costs that we have seen over the past several decades. There isn’t much of an excuse for being exploited by Wall Street, and if you really want to “stick it to the Wall Street”, I can see no better way to do that than to passively invest in index funds over a forty-year career while paying five basis points for the privilege.

Disclosure: The Rational Walk received a complimentary pre-release copy of the book.

The Revolution That Wasn’t