Behavioral Economics and the Gamification of Finance: How Apps Like Robinhood Influence Trading Behavior

Today, technology exists for anyone to “play the market” and invest in stocks, cryptocurrency, and bonds from their smartphones.  You link your trading account to your bank account and you can buy, sell, or trade at any time of day.  This has opened up the benefits of investing to virtually all adults, which can help them accumulate wealth.  However, on the flip side, this has also exposed virtually all adults to the risks of investing recklessly or negligently - pouring money into unresearched, “get rich quick” stocks and cryptocurrencies.

Like many apps, investing apps like Robinhood are designed to be user-friendly.  This includes the ability to compare the change in value of one’s investments in real time or over a range of time, such as one day, one week, one month, one year, five years, or all time.  Users may become fixated on trying to make investments that maximize their portfolio’s growth rate, viewing the change in value as a game.  This is incentivized on investing apps through appealing colors, messages, symbols, and icons that appear.  Similar to social media apps, and perhaps most apps in general, investing apps are designed to be addictive through their use of appealing colors, symbols, messages, and notifications.

Gamification of Behavior

Gamification is the use of game-like characteristics to incentivize and reinforce specific behaviors.  While some degree of gamification has existed forever, with manual distribution of notifications, praise, and non-monetary gifts incentivizing positive behaviors among students, athletes, and employees, the emergence of apps has kicked gamification into high gear.  Apps can instantly reward users with digital pins, medals, levels, etc.  Although most of these rewards have no monetary value, they provoke the brain’s release of dopamine that generates utility (the economic term for satisfaction).  Basically, we use the app, get digital rewards, and feel - at least momentary - happy.

Gamification in Finance

Prior to the rise of investing apps, some people were day traders who actively bought and sold stocks on a daily basis to try to maximize their profit.  This took time and dedication, as information about corporations was not often conveniently located in one spot.  Investing apps like Robinhood allow users quick and convenient access to information about prospective investments.  Controversially, these apps maximize convenience by allowing (some would say encouraging) users to set up regular financial deposits from their bank accounts into their trading accounts.

Gamification in fintech (financial technology) is considered controversial when it incentivizes, or perhaps even manipulates, users into trading more frequently than is safe.  This exposes users to higher risk of loss.  Critics sometimes even liken modern investing apps to gambling, with users drawn in by entertaining graphics and frequent displays of financial emblems, like dollar, pound, or euro signs.  They may come to trade stocks or transfer money to their trading accounts more often than is safe simply to experience the dopamine hit of seeing numbers and financial emblems grow.

Behavioral Economics and Animal Spirits

The study of the results of gamification of fintech, which includes online banking as well as trading apps, is part of behavioral economics.  This field of economics involves the study of psychology and sociology and their effects on economic behavior (consumption and production).  Behavioral economics was included in the work of famous British economist John Maynard Keynes through his description of animal spirits affecting aggregate demand (consumption).

In the real world, most economic and financial decisions are not driven entirely by rational thought, but also by emotion.  Human emotion can cause disruptions in markets by leading to errors among entrepreneurs, investors, consumers, and business owners.  External factors unrelated to the market can lead to people being too optimistic, and thus spending recklessly, or too pessimistic, and thus refusing to spend.  On a macroeconomic scale, this can lead to wild swings in markets, such as excess spending that drives up inflation and leads to sudden crashes.  Once the crash has occurred, excessive pessimism among consumers and investors can lead to a recession lingering due to lack of money moving in the circular flow.

Risk Tolerance Manipulation

Gamifying investing apps can be considered artificial manipulation of individuals’ risk tolerance.  This can occur when the information presented to users is biased toward that which encourages additional spending and investing.  In economics, this is the market failure condition of imperfect information: people spend money on things they shouldn’t because they lack sufficient data to make informed decisions.  While this can be the fault of spenders themselves, it could also be the intentional behavior of sellers, which could constitute fraud.

If investing apps intentionally downplay or hide information about the true risks of certain investments like stocks or cryptocurrency, they may be committing fraud.  However, there is a considerable gray area between focusing on the positive and hiding the negative.  An app that simply encourages investors to invest more frequently is not hiding the risks of investing in stocks and crypto.  And messaging that encourages investors to stay the course and invest despite temporary downturns is considered commonsense, not manipulation.

Market Efficiency Hypothesis versus Empowering Investors

Traditionally, it was believed that it was extremely difficult to “game” the [stock] market, and that investors should essentially ride the natural market gains over the long run.  This was due to the belief that major institutional investors had more information than individual investors, and that “deals” in the market were unlikely to be spotted by day traders.  Basically, it is difficult for anyone to outperform the market itself.  The lesson of the market efficiency hypothesis, created in 1970 by Eugene F. Fama, was taken by most to mean that it is best to invest in diversified portfolios and for long run growth rather than quick profits.

The market efficiency hypothesis leads to many individuals investing at lower levels of risk-tolerance in vehicles like IRAs, 401Ks, mutual funds, and exchange traded funds (ETFs), which are naturally diversified.  This helps reduce diversification risk and is one of the most common pieces of advice when investing.  Theoretically, if your portfolio is sufficiently diversified, your investments will increase in value at the same rate as the stock market as a whole.  Over the long run, this will lead to a solid “nest egg” and considerable profit.

However, the ability of individual investors to conduct rapid trades through apps has revealed new power held by these individuals (known as retail investors) versus institutional investors (investment firms) like Morgan Stanley, Vanguard, and BlackRock.  Famously, the GameStop trading scandal of 2021 revealed that many retail investors, working together, could significantly affect the value of a stock.  The results revealed deep tensions among investing apps like Robinhood, retail investors wanting to cash out, and institutional investors.

During the trading frenzy around GameStop in January 2021, Robinhood began limiting trades from its retail investors, sparking cries of manipulation and fraud.  Did Robinhood violate laws by not acting in its customers’ best interests?  The fact that Robinhood did not charge fees to trade made the situation more complicated: what duty did it owe if it was executing trades for free?  This makes the gamification of finance more controversial, as users are tacitly encouraged to invest or spend more, but may not be given fair treatment by those encouraging the spending.

Regulatory Questions

Investing apps have empowered retail investors, but questions remain about to what degree these free apps should be regulated.  Critics argue that they manipulate consumers into overspending through gamification and do not always pay out as promised, such as during the GameStop frenzy.  Happy users of the apps counter that they should be given the freedom to invest as they see fit and not have to rely on investing firms.  They argue that much talk of regulating investing apps comes from wealthy institutional investors, such as hedge funds, who are upset at being outperformed by amateurs and are arguing for “consumer protection” in bad faith.