The immediacy of the online environment appeals to personal investors, in part because it allows them to respond more quickly to market fluctuations.
Online pioneers from DLJdirect to E*Trade and Ameritrade helped shape the new industry in the early to mid-1990s. By the late 1990s, online trading hit its stride, as a bevy of investment stalwarts from Charles Schwab to Merrill Lynch debuted their online trading services. Only recently, with the arrival of last year's bear market, have some online brokers begun to report lower commission revenues, a slide that may reverse itself once the economy shows signs of stabilizing.
Meanwhile, industry pundits speculate that the rise in online trading over the past few years resulted in a measurable boost in stock market trading activity. Finance professor Andrew Metrick, for one, believes the Web has had an unmistakable effect on investor behavior, an impact whose effects, he says, "we are still capturing."
In a recent research paper titled "Does the Internet Increase Trading? Evidence from Investor Behavior in 401(k) Plans," Metrick, along with co-authors James J. Choi and David Laibson of Harvard University, looked at the influence of online trading at two corporate 401(k) plans. The researchers started with the premise that if the Web's influence on trading were to be detailed in a substantive way, an analysis of the trading behavior of 401(k) participants, generally considered more conservative investors, would offer up interesting insights on the subject.
In their paper, the researchers noted that the Web's influence on the average investor may have been difficult to assess in the past, especially since prior research on the subject detailed the online behavior of "self-selected" discount-brokerage customers. To address that issue, the authors chose to study about 100,000 participants in two corporate 401(k) plans. Assets in these plans can be transferred between investment options through either a phone call or the Web. The authors used data from Hewitt Associates, a large provider of administrative and consulting services to corporate 401(k) plans.
Does the Net affect the 401(k)?
As part of their research, the authors studied the effect that the addition of a Web channel had on trading at both plans. They also compared data from the two unidentified 401(k) plans against a set of large 401(k) plans without a Web trading option, to determine a more "causal role of the Web" in investor actions.
The authors found that after 18 months of access, "the Web channel nearly doubled the daily trading frequency" for one of the plans, simply identified as "Alpha." The "traded fraction of portfolio value" or "turnover" also experienced growth as a result of the introduction of online trading for Alpha plan participants. According to the research, the daily turnover for the same 18-month period jumped by more than 50 percent. The second plan studied, referred to as "Omega," demonstrated similar results after the institution of online trading.
Demographic information on firms Alpha and Omega was "limited to participants who had positive plan balances or plan activity in 1998 or 1999." The authors used a data range of May 19, 1997, to March 3, 2000, for Alpha and Jan. 1, 1997, to Jan. 26, 2000, for Omega. Both plans launched the Web channel in August 1998. Before online trading, plan participants conducted transactions via the phone. Across both plans, an average of 60 percent of assets are invested either in equity mutual funds or in company stock.
The paper found that "frequent traders" remained uninfluenced by the introduction of the Web channel at the two plans and were "less likely to try the Web." Metrick notes that this information was one of the most surprising conclusions of the research. "We expected that frequent traders would also be the types of people who wanted to check their accounts often and generally 'play' with the Web," he says. "Instead, it appears that these participants' experience transacting by phone makes them more likely to stick with that medium."
More telling, however, was the behavior of investors who used the Web for the first time. Of the plan investors who traded online, the research paper showed that an increasing number are likely to use the Web again. After their first Web transaction, 10,413 participants in both plans "made at least one more trade; of this group, 9,172 (88 percent) made their next trade on the Web." The paper documented that "with each subsequent trade on the Web, the probability of making the next trade on the Web increased dramatically, "with an empirical frequency of 94 percent on the third trade and 96 percent on the fourth trade." The frequency of Web trading increased as online transaction costs declined.
The grocery effect
Having the option of the Web is like having a grocery store move closer to your house, Metrick says: It results in more trips to the store with fewer purchases on each trip. "The same thing appears true with Web and phone transactions. We see a greater number of Web transactions but each one is smaller than their counterparts on the phone." Thus, the authors determined that "the Web effects on trading frequency are proportionally larger than the Web effects on trading turnover, because Web trades are expected to be smaller, in dollars, than phone trades."
The research supported the contention that "young, male and wealthy participants are more likely to try the Web for trading." These participants appear to hop on the online trading bandwagon earlier, as they tend to be more computer-literate.
One of the more interesting points of the research paper involves the effect of online trading on short-term investment behavior. The authors posed the question: "Does the fact that trading is only a 'click' away lead participants to more short-term behavior?" Many industry analysts initially speculated that the answer to this question would be a resounding "yes."
However, Metrick believes that the Web "has not had as much of a speculative effect, as it has had a democratizing effect on the trading environment." The research paper would seem to confirm his contention. The authors looked at what they termed "reversed trades," plan trades that were "partially reversed within five trading days," as a benchmark to study short-term trading behavior. For both corporate 401(k) plans evaluated, phone transactions had a higher reversal rate than online trades. As the authors conclude, the Web's long-term effect on investing appears to be sizable and growing. "I expect that overall trading will increase for a few more years before settling down into a new equilibrium," Metrick says. Unfortunately, he adds, "In normal, everyday, taxable accounts, more trading usually just means more transaction costs and more taxes, with little financial benefit to the trader."
To read more articles like this one, visit Knowledge@Wharton.
All materials copyright © 2001 of the Wharton School of the University of Pennsylvania.