Herding and Financial Markets: The case of REDDIT daytraders versus Hedge funds

Abstract

The whole world was shocked. On January 28, 2021, the Financial Times reported that a group of small investors beat the hedge funds (Wigglesworth, 2021). These investors made 300% returns in one day, and about 1500% in 2 weeks, while the hedge fund Melvin Capital lost more than $4.5 billion in January (Schroeder, 2021). The question is, what happened? It may be good to provide a small introduction for a non-financial audience as a background to the case. As you know, the stock market trades in shares that represent ownership in a company. After obtaining shares from a company, investors buy and sell these shares in the secondary market. They pay a commission to the broker who gets the shares for them. Supply and demand establish the price as shown in the top panel of Figure 1. If demand increases, the price goes up; if supply increases, the price goes down; and there is some equilibrium price. As seen in the bottom panel of figure 1, investors can make profits by buying low and later selling high, hoping that price will go up from P0 to P1 in the figure. But one could also sell high and later buy low. Hedge funds backed by high net worth investors do this, hoping the price would go down from P0 to P2. One problem with the system is that the commission per share charged to big investors is much smaller. If a broker is given a deal of €1 million, he could ask for a commission of €1000, which is 0.1%. But if a small investor wants to make a deal of €1000, the broker may ask for at least €10, which is 1%. The point is that the commission percentage is higher for small investors, and the game is biased in favor of the rich. To compete effectively, small investors get together in mutual funds. Once their collective trades are larger, they get the advantage of smaller fees, but they have to pay fund management fees. Besides reducing the commission costs, investors in mutual funds also have lower risk since they can diversify into many stocks.