Investing, Online

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INVESTING, ONLINE

As the Internet opened to the mass public in the 1990s, it didn't take long for investors to see the potential for buying and selling securities online. While forms of online investing existed before the Internet became popular, the proliferation of Internet access and the coinciding stock market boom ushered in a vast industry catering to all kinds of investors. The Internet had something to offer for individual bidders, those who worked through brokers, and both aggressive and defensive investors. Between late 1998 and late 2000, the number of stock-owning households that supplemented their investments with online trading more than doubled from 10 percent to 21 percent, amounting to about 10 million households, according to Jupiter Communications.

Online investing generally is well within the reach of any Internet user with enough cash to risk in the market. Meanwhile, mountains of information about investing and up-to-the-minute updates about worldwide markets turned investing into a populist sport in the 1990s. In addition, entering buy and sell orders to online brokers typically carries lighter commissions, thereby allowing the investor to hold on to more of what he or she earns in the market. As a result of these potential benefits, the Internet was inundated with Web sites catering to all manner of investors, from neophytes to professionals, from fund managers to day traders. Supplementing these sites were countless forums, mailing lists, and discussion groups where users could discuss stock market wisdom, trade tips, perpetuate or dispel rumors, and compare investing war stories.

THE ACTORS

INDIVIDUALS.

One of the most widely proclaimed glories of online investing was its potential to democratize the securities markets and spread the wealth among broader segments of the population. The convenience, low barriers to entry, and technical ease of trading over the Internet thus spurred a massive influx of individuals taking control over their own financial investment schemes. Forrester Research expected the number of online investors to rise from 1.1 million in early 2000 to 7.2 million in 2003, and reported that about 26 percent of all Americans connected to the Internet to regularly check their stocks. This nearly was as high a percentage as those who regularly read the news online. By putting such a fantastic wealth of financial information only a mouse-click away, the Internet fosters the idea that becoming an investor is well within reach of the average Internet user. In addition to keen market insight, experienced online investors boast sophisticated software for charting and technical and fundamental analysis. A number of Web sites offered free real-time stock quotes.

The reach of online investing even extended to children. According to Business Week, nearly one in five students in grades eight through 12 owned stocks or bonds in 2000, up from 10 percent in 1993, while some 2 million actively traded and picked their own stocks. Able to bypass their parents by connecting to the Web at home or even in school, students increasingly sought to reap their own fortunes and a measure of financial independence via online investing. And many succeeded; the bull market of the late 1990s produced scores of teenage success stories in which young students amassed fortunes on par with or exceeding many successful adults. Juveniles typically require parental approval to open accounts; parents usually maintain custodial accounts for their children. However, as long as children know the account's password they can trade freely of their own accord.

The online investing boom launched its own breed of individual investor: the day trader. Day traders generally were non-traditional investors, often fancying themselves as rebels in the investment world, with few or no ties to large brokerages or market makers. Day trading and electronic trading were a perfect match, with the latter pitched as a vehicle by which the market was democratized and wrested from the exclusive hands of traditional market players. Day traders work by sheer volume and speed, purchasing a flurry of securities early in the day and unloading them all by the time the markets closed, with the goal of profiting from the incremental price movements of those securities throughout the day. While on average these fluctuations were miniscule for individual securities, by purchasing mountains of securities day traders hoped that the tiny gains would combine to reap tremendous rewards.

Inevitably, this unorthodox investment practice turned out to be controversial. Analysts chalked up no small amount of the market volatility in the late 1990s to the day traders, who critics claimed undermined the ability of public companies to maintain steady projections of cash flow and thus effectively plan for the future. In addition, employers feared that day trading was eating into their employees' work hours, prompting many businesses to install software designed to block employees out of day-trading sites.

The backlash against day trading reached its zenith after a distraught Atlanta day trader went on a shooting rampage, killing 11 individuals and himself. Day traders were roundly accused of typifying the over-exuberance of investors in the late 1990s. Professionals likened day trading to gambling by amateur investors rather than reasoned investing strategies. Repeated research concludes that the more traditional buy-and-hold strategy, despite the dramatic success stories of the late-1990s bull market, are much more profitable than quick in-and-out investment behavior. To illustrate this point, analysts pointed out that go-it-alone investors were the hardest hit by the poor performance of the stock markets, particularly the NASDAQ, in the early 2000s. Still, the effects of day trading were profound, altering perceptions of risk exposure and boosting the degree of market volatility, which both made and lost vast fortunes.

BROKERAGES, OLD AND NEW.

At first, major traditional brokerages such as Merrill Lynch, Morgan Stanley Dean Witter, and Salomon Smith Barney were slow to adopt online trading as part of their services. However, after watching the explosive growth of electronic communications networks and individual online investing, they too jumped online to catch up to the upstarts. Gomez Advisors reported that the number of online brokerages jumped from 12 in 1994—the year the first brokerages went online—to more than 140 by the end of the 2000, though by then a shakeout was imminent. Meanwhile, Forrester Research projected online brokerage accounts for stocks and funds would reach $1.5 trillion by 2003.

While most online brokerages simply set up a Web site through which they conduct transactions, some—including CyberCorp (which was purchased by Charles Schwabb), myTrack, and TradeCast—eschew Web browsers altogether and allow their clients to link directly to the brokerage trading desk using proprietary software. This method tends to call for greater bandwidth and was thus inconvenient for many Internet users. However, the software, which users normally downloaded from CDs, usually carried vastly more—and more sophisticated—features than were available on most Web sites.

Having received an order, electronic brokers have a variety of procedures for processing the transaction. For instance, the brokerage may pass the order through an approval process verifying that the client is authorized to trade in particular securities. Then, once approval is met, brokerages transfer the order to either an electronic trading system such as NASDAQ, or to their own agents located on the floors of exchanges like the New York Stock Exchange, depending on where the particular security is listed. Alternatively, online brokerages may choose not to go directly to the trading centers themselves, but opt instead to channel orders through market makers. Third-party market insiders, market makers enjoy the financial backing of major investment banks and brokerage houses. They rush to fill open buy and sell orders for their clients, thereby providing them with instant liquidity.

Online brokers generate revenues primarily from two sources: the commissions charged to the investor for processing his or her order, and from a percentage of the market maker's spread—the difference between the buy and sell price that constitutes the market maker's profit.

Leading online brokers such as E*Trade, Ameritrade, and Datek ascended to prominence almost under the noses of the established powerhouse brokerages. By the end of the 1990s it was the stalwarts who were humbled and playing catch-up. The perpetually rising bull market encouraged increasing trading volume through these channels. However, after the market went bust in early 2000, many analysts realized that all too many online investors and online brokerages were confusing the bull market with individual market savvy and know-how. The early 2000s were characterized by layoffs and losses among online brokerages.

No brokerage made it through the sour turn in the market unscathed. However, traditional brokerages, with greater diversity and economies of scale, were able to weather the storm much better. In the meantime, such brokerages sought to purchase or drive out much of their upstart competition, realizing that while the bull market may well be in hibernation, the trend of online investing was here to stay. In their defense, the largest online brokers sought out partners with deep pockets to help them diversify their offerings and float them through the tough times. As a sign of trends to come, E*Trade partnered with Ernst & Young in 1999. Most analysts expected that the line between traditional brokerages and online brokerages would blur and eventually dissolve altogether in an industry that seamlessly integrates both varieties.

According to Business Week, online brokers bore some of the responsibility for feeding investors false promises. Many brokerages advertised to customers by ensuring that millions could be earned by investing, based solely on information derived from the Web. While the ultimate responsibility for investments lies with the investors themselves, analysts point out that if the online investment industry were to continue to grow and go mainstream, a more responsible atmosphere would need to take hold.

ELECTRONIC COMMUNICATIONS NETWORKS.

Electronic communications networks (ECNs) are digital trading systems where investors post their buy and sell orders, which are then matched to other bids electronically, bypassing market makers and other middlemen altogether for significant cost savings and high speed. ECN clients include online brokerages, institutional investors, and individual investors. In the late 1990s, the bread and butter for ECNs was the day trading phenomenon, which brought in the overwhelming bulk of their business. Since trading volume was the path to riches for ECNs and day traders alike, their models fit perfectly in the 1990s bull market.

ECNs emerged as a significant threat to major exchanges—particularly NASDAQ—by the early 2000s. This prompted such exchanges to vastly overhaul their trading systems and technological infrastructure and practices, often adopting architectures similar to that of ECNs. By 2001, ECNs accounted for more than one-third of the total trading volume on NASDAQ. While ECNs directly challenged both exchanges and market makers in the late 1990s, the early 2000s saw major brokerages such as Merrill Lynch and Goldman Sachs increasingly investing in ECNs, perhaps recognizing that the model of investment they offer has produced an undeniable shift in investors' expectations.

Either individually or through a brokerage, investors enter their bids. These are then listed anonymously in the ECN's electronic order book while the system searches out the book for a corresponding bid—for instance, a buy price that matches the proposed sell price. Increasingly, ECNs eschewed a closed system—in which buy and sell orders are only matched within that system—in favor of a model that linked various trading systems together in an open network, thereby facilitating greater liquidity and faster transactions.

Unlike brokerages, ECNs don't actually process orders for investors. Rather, they simply provide networking space where investors can find each other and have their buy and sell bids met. ECNs earn revenue by applying a miniscule surcharge—usually less than a few cents per share—to the transactions that take place on their network. Thus, ECNs rely on the sheer volume of trading to stay afloat, rather than on the spreads between buy and sell prices.

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.