When Gary Gensler’s confirmation hearing takes place today, senators will scrutinize how president Biden’s pick to run the Securities and Exchange Commission would wrestle with the retail trading boom enabled by brokerages like Robinhood. If his book is any indication, Gensler would tell everyday investors that they shouldn’t try to beat the stock market.
“Americans are losing billions to the mutual fund and brokerage industries,” according to the jacket cover of Gregory Baer and Gensler’s book The Great Mutual Fund Trap, first published in 2002. “While at Goldman Sachs, Gary would often be asked be asked for stock-picking advice,” they wrote. “He always responded that passive investment was the best option, though friends and family mistakenly thought he was being coy.”
Members of the Senate Banking Committee—and anyone who has downloaded a stock-trading app—should read Part III of the book, titled “The Great Stock Picking Hoax,” in which Baer and Gensler list day trading as one of the “four dumbest ideas in human history.” They cite research based on 2 million trades during a six-year period showing that “individual investors significantly underperform the market.” The research shows that retail traders tend to sell stocks that outperform the ones they buy, Gensler and Baer say, demonstrating a lack of stock-picking prowess.
The tsunami started to build in late 2019 when a price war among US brokerages stomped out trading commissions. It got a boost after the Covid-19 pandemic shot a hole in the stock market, giving rise to bets that it was a chance to buy stocks on the cheap, at a time when many people were locked down because of the pandemic, with little to do. Last month, Congress held a hearing to discuss the GameStop saga, in which an army of retail investors conspired on Reddit’s WallStreetBets channel to take on hedge funds that were betting against the video game retailer.
To be fair to Robinhood, Schwab, and other brokerage apps, the cost of trading is much lower than it used to be, and that expense has historically been a big reason that everyday investors have underperformed compared with broad stock market indexes. Even so, Baer and Gensler’s book stresses that regular people, as well as professional investors, are typically unable to beat a stock index. They crunched 14-years of Wall Street Journal data comparing professional investors’ stock picks to those chosen by throwing darts at a board. Over longer periods, the darts won.
Indeed, the likes of Robinhood make money by selling their customers’ orders to professional traders who execute those transactions. The professionals wouldn’t have any interest in executing those trades if retail investors had special insight about the market’s toing and froing. (You can read more about how Robinhood makes money through payment for order flow here, and here.) The cost of trading, meanwhile, hasn’t evaporated completely—there’s still a cost buried in the spread between the bid and the offer, and traders who make bets using margin, or money borrowed from the brokerage, are paying another expense that eats into returns.
Most people would be better off with cheap, boring index funds, Baer and Gensler wrote, and they offer advice about how to get rid of active investments and move into so-called passive investing. They were skeptical that index trackers would be exciting enough to interest most people—”No one has ever said anything witty or charming about index funds”—but it has become a full blown phenomenon since their book was published. Passive funds accounted for about half of the assets in equity funds in March 2020, up from around 5% in 1995.
This line of thinking came up when Congress grilled financial executives over the GameStop episode last month. Congressman Jim Himes asked Robinhood chief Vlad Tenev how his customers’ rate of return compared with the S&P 500 Index of large US companies. Tenev didn’t provide that information and said the question was flawed. It would be better, he said, to compare their returns to what they would have gotten if they hadn’t invested at all.
Baer and Gensler seemed to anticipate this question, and Tenev’s reaction, in their book more than a decade ago. Their writing also suggests a potential policy change—requiring brokers to provide more disclosure about client performance—if Gensler is confirmed to run the SEC: “We strongly believe that brokers would be all too happy to release aggregate information about the performance of their clients if the news were good,” they wrote. “But don’t hold your breath.”