Online Investing - The Online Investing Phenomenon

THE ONLINE INVESTING PHENOMENON

Electronic trading had its genesis in the desire by institutional investors to be able to trade after hours. In 1969 Reuters Group PLC founded Instinet Corp. for just this purpose. Thus, while online trading eventually would come to prominence as a populist practice, its origins lay in the demands of a relatively exclusive club of established investors.

The three primary advantages attributed to online investing are the lower commissions levied on trades, around-the-clock portfolio access, and greatly enhanced access to and control over the investment process. However, simply giving individuals greater access and control means that those same individuals, to truly take advantage, must familiarize themselves with the wealth of global market information available on the Internet. They also must become familiar with the subtle techniques—and enormous potential risks—involved in playing the securities markets.

Much of the online investing climate in the late 1990s was advertised as rugged individualist and even anti-establishment. However, effective stock research, trade execution, and portfolio management were all highly sophisticated and knowledge-heavy endeavors, particularly in times, like the early 2000s, when the bull market turned bearish. Before the online investing craze took hold, these practices usually were the purview of professional brokers. But the democratization that the Internet promised spurred a demand for greater individual control, and the bull market reaped enough reward to make this widely applicable.

The availability of the Internet as a convenient and relatively democratic investment vehicle helped to transform the nature of financial markets by stimulating vastly greater movement of securities prices and resultant market fluctuations. For instance, analysts frequently noted the decline of the buy-and-hold mentality among the investor pool, whereby investors purchased stocks with the intention of holding onto them for some length of time, thereby providing longer-term financial streams to the companies. Instead, online investors were more likely to purchase stocks and unload them in a relatively short period of time, simultaneously contributing to and hoping to profit from rapid market fluctuations. This certainly was true of day traders, who operate under this logic by definition. However, other online investors also helped to shrink the average period of time that an individual investor holds on to a particular security.

In 1999, University of California at Davis professors Brad Barber and Terrance Odean released the results of their study of about 1,600 investors between 1992 and 1996—just before the thrust of the online investing boom—who abandoned telephone-based, broker-mediated trading in favor of online investing. On average, these investors were active traders, with about 75-percent annual portfolio turnover. Before their switch, they bested major market indexes—a composite of the New York Stock Exchange, NASDAQ, and the American Stock Exchange—by a healthy 2.4 percent.

After turning to online trading, their trading activity increased substantially, with annual portfolio turnover reaching 96 percent. However, their performance fell to 3.6 percent behind the indexes. Barber and Odean concluded that the convenience of online trading was accompanied by a combination of over-confidence and over-exuberance, with traders more and more itchy to trade and capitalize on presumed knowledge based on past successes. Thus, despite the lower commissions spent on online trades, the investors actually incurred higher transaction costs due to their more active and speculative trading.

Odean and Barber explained that online trading fostered an illusion of greater control through the use of computers to make trades. This was because information was at one's fingertips. They also explained that, in general, for all but the most experienced investment professionals, highly active trading is not as beneficial as the buy-and-hold model.

Finally, online investing reached its zenith alongside the euphoria surrounding the dot-com market and the great fanfare over the new economy. According to critics, as these factors coalesced, an environment was established whereby investors grew convinced that the market could do no wrong, that the laws of economics and securities trading had fundamentally changed, and that to fail to take advantage of can't-miss opportunities was to risk missing out on a financial windfall. Supported by enough success stories, this mythology floated both the online investing boom and the new economy for awhile. However, when the high-tech and dot-com sectors plummeted in the early 2000s and the new economy turned sour, analysts turned sour on online investing, particularly in the form of day trading. While the excesses of online investing fell into disrepute, there was little doubt that the transformations of financial markets and the trading industries were here to stay, and that online investing would continue as a major sector of the trading world.