Intense engagement doesn’t align with buy-and-hold behavior

Making financial chores more engaging can be a great way to nudge us to stick to the drudgery of saving and budgeting. But when applied to investing, apps that add an element of gamification can encourage behavior that reduces the odds of long-term financial success.

That’s the crux of a legal complaint the State of Massachusetts filed against the online trading app Robinhood, which has enjoyed explosive growth in the past year, appealing to inexperienced investors with free trades and a screen interface that applies all sorts of gamification nudges.

Massachusetts requires financial firms to act as fiduciaries, which simply means they need to put a client’s interest first and foremost. The complaint claims that features of the Robinhood platform don’t necessarily put the financial well-being of the customer front and center.

Some Robinhood features:

— Open an account and Robinhood will deposit a share of stock (their choice) in your account. That can serve as a psychological anchor — Hey, this stock must be good! — when no analysis has been conducted or appropriateness considered.

— The most popular stocks being traded on the app are prominently displayed on user screens. As if following the crowd of other newbie investors is some sort of sound investing strategy.

— Make a trade and your screen is littered with celebratory confetti raining down. Not necessarily a profitable trade, just any purchase or sale. As if the trade itself is the win. The only guaranteed win for a trade flows to Robinhood, as the firm gets paid by third parties who execute the trades.

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— Want to move up on the waitlist for a cash management feature launched on the site? You can tap your way up the list, though there is a limit of 1,000 taps per day. Yes, 1,000. Per day. More face time with the app is yet another nudge to consider trading.

Delivering a Candy Crush sensibility to investing is pretty much the opposite of what academic research has shown is the key to long-term success: Buy-and-hold investing produces superior long-term returns, compared with active trading.

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In its complaint, Massachusetts identified at least 241 accounts since 2017 in which customers who had no experience investing traded at least five times a day. Per day. The complaint lists 25 inexperienced traders who averaged anywhere from 15 to 92 trades a day during the period reviewed. The complaint also says that nearly two-thirds of users whose records it examined were approved to trade stock options and self-reported that they had no or limited investing experience.

A key feature of the Robinhood platform is an enticing reward itself: commission-free trades, a nudge that encourages more trading.

Trading in regular (non-retirement) investment accounts generates a tax bill. Any investment sold at a profit that is held less than one year is subject to the short-term capital gains tax, the same as the individual’s income tax rate. In the next few weeks, Robinhood will send customers their 2020 IRS Form 1099, which spells out their taxable capital gains.

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Plenty of Robinhood users indeed made money last year. From the bear-market low in March 2020 through the end of the year, the S&P 500 gained nearly 70%. It’s easy to mistake luck and good timing for long-term insight.

Reality check:

Would you make a trade if it cost you $10 or $20? Free can be costly if it entices you to make a lot of trades without careful consideration.

Keep it on the side. It’s likely no coincidence that Robinhood has become increasingly popular during the pandemic. Without sports to watch (and gamble on) or concerts to attend, and with limited ability to hang at a bar, boredom is sort of a given. Into that void comes a new “game” of investing. Fair enough. But if actively trading stocks has become your go-to entertainment/rush these days, don’t invest more than your regular entertainment budget. The main dish is saving for retirement using diversified mutual funds and exchange-traded funds in your 401(k) and/or IRA.

Check your cockiness. One of the smartest investing approaches is to ask yourself every once in a while, “What’s the consequence if I am wrong?” In online day trading, what happens if your portfolio falls 20% to 40% (a garden-variety bear market)?

Considering opening a margin account? Margin is when the brokerage lends you money to buy shares. If your portfolio goes up, you have more profit. But if you borrow money, buy stocks and they lose value, you have more losses, and the brokerage may force you into a “margin call,” in which you either need to pony up more money or sell stock to raise the balance in your account.

At the end of November, total margin borrowing by individual investors was at a record $722 billion, up more than 30% since right before the pandemic.

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Here too, Robinhood recently offered a nudge to customers who qualify for a margin account. In late December it announced it had reduced the interest rate charged on margin borrowing above $1,000 from 5% to 2.5%.

That will look like cheap borrowing if the markets continue to move higher. But that’s a mighty big if, especially with the markets at all-time highs.

However, there’s hope for gamification, with financial apps that help you save, not spend.