Stock trading apps that encourage novice investors to start with as little as $1 could actually be limiting the amount of wealth the next generation accumulates.
An academic study published in May, 2023 looking at investor behaviour showed that the size of the first stock trades greatly predicted the size of future purchases. If an investor started with a $5 trade, they were more likely to make the same size of trade subsequently – a phenomenon called “anchoring.”
And that matters, because the very modest-sized investment amounts that easy-access trading encourages means investors don’t get as great a benefit from compound returns over time. That ultimately leads to lower wealth accumulation.
The research, which was published in the Journal of Behavioral Finance, looked at one particular app-based brokerage in the United States that advertises no account minimums to start trading, standard commissions of 99 US cents per trade, and the availability of fractional share trading.
Fractional shares are key in allowing a small investor to trade in the most popular stocks. For example, in order to buy one single share of Tesla an investor would need hundreds of dollars. (Tesla shares were changing hands at about US$234 in midday trading on Nov. 20). If a brokerage makes fractional shares available, you could place an order to buy $10 worth of Tesla stock and the brokerage would convert that into around 0.04 of a share of Tesla in your account).
What was particularly interesting about this trading platform was that it offered gift cards. These could be purchased by other people and given to help new investors place their very first trade. This allowed the researchers to see if gifted-funding versus self-funding for a first trade would still be subject to anchoring.
It was. And this is important because gifted funds from other people determined the size of the first trade, not the investor themselves, who you would imagine would think about their first trade size as some function of their income and financial capability overall.
That being said, other factors that would influence trade sizes, such as income and age, were also controlled for. And while 21.8 per cent of accounts were custodial accounts for minors, 33 per cent of account holders were between 33 and 54 years of age. The anchoring effect was present for everyone.
Early in an investor’s journey, the size of contributions trumps rate of return. Suppose you contributed $200 a month for 10 years and were only able to earn a rate of return of 1 per cent. You’d end up with roughly $25,229.98. Contribute only $100 per month, and in order to end up with the same amount you’d need a rate of return just over 13.5 per cent. Earning that rate would be unlikely for even the most seasoned investors.
The ideal balance would see good risk-adjusted returns along with a healthy contribution rate; one without the other is suboptimal in terms of wealth accumulation over time.
So, while so-called “micro-investing” apps encourage stock market participation for younger and lower-income investors, they run the risk of simultaneously encouraging a lower long-term wealth trajectory as a function of never getting investors out the “start small” phase.
What is worse? Not encouraging new or small investors to participate in stock market investing? Or anchoring their potential wealth accumulation lower through the very same inducements that encourage participation?
Anchoring for contributions can also exist for traditionally advised investors. If a monthly contribution rate was initially set up for $250 per month, there can be a tendency for that number to be an anchor on which future increases are based. That may not always be the best approach.
“Let’s increase that contribution by 10 per cent” seems like a simple enough decision, but a planning-led engagement might also want to consider evolving goals and performance and lead to a potentially more ideal, “We need to increase monthly contributions by $100 per month.”
In the end, whether investors go the DIY route or through a traditionally advised engagement, increased contribution rates are critical for new investors. Whether these are achieved through automated prompts, auto-escalation options for preauthorized contributions, financial literacy interventions from brokers, or similarly reducing barriers to light financial planning, contribution rates trump investment decisions early on.
Preet Banerjee is a consultant to the wealth management industry with a focus on commercial applications of behavioural finance research.