Investors these days. They just don’t seem to hate losing money like they used to.
In theory at least, the human brain is hardwired to fear and loathe financial losses.
Investors are said to feel the emotional pain of a loss twice as intensely as the pleasure of an equivalent gain. For decades, this idea has served as a foundational principle of behavioural economics.
Generations of investors have been loss averse to a fault, in fact. Excessive caution and fear-driven trading is a big reason the investing masses tend to realize lower returns than their investments generate.
But then came the stock market craze of 2021, and with it, an all-consuming impulse in direct opposition to loss aversion: fear of missing out, or FOMO.
The trading frenzy lured in hordes of new retail investors and wannabe day traders emboldened by the easy money to be made in meme stocks, SPACs and cryptocurrencies.
The bubble popped, of course. But some of the speculative excesses remain in the attitudes of everyday investors.
The latest retail boom is in zero-days-to-expiration options – or 0DTE in trader parlance – which represent single-day bets on the direction of markets.
Until very recently, this was the kind of sophisticated trading tool relegated to professionals. But retail investors have piled in and now account for about a third of all trading in 0DTE options tied to the S&P 500 index, according to CBOE Global Markets.
This latest investing fad raises the question: Has FOMO permanently hijacked investors’ brains?
“FOMO still presents itself powerfully in the stock markets,” said Brian Madden, the chief investment officer of First Avenue Investment Counsel. “I think a big population of equity market investors feels the pain of missing out as much more than just a temporary setback of paper wealth.”
There’s nothing new about investors getting swept up in an investing mania. The stock market’s swings are driven in large part by the competing emotions of fear and greed.
But this is no boom cycle. Last year brought a painful reckoning to financial markets after the exuberance ended. And this year hasn’t been great for stocks outside of a handful of tech giants and beneficiaries of the rise in artificial intelligence.
Even so, there still seems to be a willingness to gamble in financial markets, risking outsized losses for the chance of a big payday.
Commission-free trading on platforms such as Robinhood has given people easy access to financial markets, while the ETF revolution has put in their hands the instruments of hedge fund traders.
Options trading, for example, has traditionally been used by large investors to hedge portfolios. In early 2021, individual investors accounted for almost 30 per cent of U.S. options trading volumes.
Call options, for example, involve placing a bet on a stock rising above a specific price within a particular time period. If that bet pays off, the gain can be 10 times greater than simply investing in the underlying stock, depending on the terms of the option contract. If the stock stays below that price, the investor loses the entire amount.
0DTE options reduce the duration of those contracts to a single day or even a number of hours. 0DTE options now make up half of all S&P 500 options trading activity, according to JPMorgan.
“It’s a great case in point of the FOMO mentality,” Mr. Madden said. “There is a lot of professional money sloshing around in those instruments, but they’re widely available and accessible, and it’s like rocket fuel for a speculative retail investor.”
Traditionally, the bigger problem for advisers and financial planners was in convincing investors to take on enough risk. Excessive loss aversion can result in overly conservative portfolios and ill-advised selling when the market is in decline.
Loss aversion is largely to blame for a persistent shortfall between individual investor returns and the performance of broad financial markets. A few years ago, robo-adviser Betterment tried to quantify that gap and found that, on average, investors sacrifice between 1.4 per cent and 4.3 per cent in annual returns by letting their emotions get the best of them.
A new breed of investors with fewer reservations, however, has found new ways of losing money.
Researchers from the London Business School recently estimated that retail investors have lost US$2-billion in options trading since the start of the pandemic. These investors tend to focus on short-term instruments with big potential losses and very low chances of paying off, their research showed.
One of the first hints Mr. Madden said he got that a generational shift in investor psychology may be at work came when he spoke to a high-school investing club a couple of years ago.
“It was heartening to see these kids interested in investing,” he said. “But when it came time for questions, all they wanted to know about was SPACs and meme stocks.”