Coming of age: young investors & the rise in riskier investments

By the year 2034, Generation Z (currently those between 12 and 25 years of age) is projected to become the largest generation with an estimated 78 million individuals (Morgan Stanley, 2014). In all respects, this rising generation is taking the world by stormespecially in the investment sphere. Not only are there more young investors than any generation that proceeded them but they're also more likely to take risks- knowingly or unknowingly. A basic framework for making an investment decision includes defining one's investment objectives, researching opportunities, and allocating funding across selected assets. While Gen Z is just as motivated to save for retirement as the older age groups, they're also the most interested in getting rich. Influenced by their heavy utilization of social media, young people are making investment decisions contrary to sound financial principles; this includes taking on debt to invest and by buying assets with arguably no intrinsic value. On the contrary, this generation is expected to be the most educated with the highest probability of having college educated parents. They are also consuming less alcohol and have less teenage pregnancies than previous generations (Hawkins et al., 2022). Millennials and Gen Z are investing in retirement at a younger age than their parents and grandparents and strive for financial independence. Consequentially, many young investors are doing their own investment research as opposed to using index-based mutual funds or by working through financial advisors. iii While many would argue that financial markets are efficient, these ‘young guns' don't believe that's the case and are willing to make trades against it. Their extensive involvement in high frequency trading has led several behavioral finance professionals to correlate it with gambling, especially as young investors seek high short term yields as opposed to consistent investing. This paper will analyze how the evolution of equity market trading has allowed for increased access to markets in modern times. It will also relate generational differences between investors to compare risk tolerance and investment preferences.

ABSTRACT By the year 2034, Generation Z (currently those between 12 and 25 years of age) is projected to become the largest generation with an estimated 78 million individuals (Morgan Stanley, 2014). In all respects, this rising generation is taking the world by stormespecially in the investment sphere. Not only are there more young investors than any generation that proceeded them but they’re also more likely to take risks- knowingly or unknowingly. A basic framework for making an investment decision includes defining one’s investment objectives, researching opportunities, and allocating funding across selected assets. While Gen Z is just as motivated to save for retirement as the older age groups, they’re also the most interested in getting rich. Influenced by their heavy utilization of social media, young people are making investment decisions contrary to sound financial principles; this includes taking on debt to invest and by buying assets with arguably no intrinsic value. On the contrary, this generation is expected to be the most educated with the highest probability of having college educated parents. They are also consuming less alcohol and have less teenage pregnancies than previous generations (Hawkins et al., 2022). Millennials and Gen Z are investing in retirement at a younger age than their parents and grandparents and strive for financial independence. Consequentially, many young investors are doing their own investment research as opposed to using index-based mutual funds or by working through financial advisors. ii While many would argue that financial markets are efficient, these ‘young guns’ don’t believe that’s the case and are willing to make trades against it. Their extensive involvement in high frequency trading has led several behavioral finance professionals to correlate it with gambling, especially as young investors seek high short term yields as opposed to consistent investing. This paper will analyze how the evolution of equity market trading has allowed for increased access to markets in modern times. It will also relate generational differences between investors to compare risk tolerance and investment preferences. Keywords: Generation Z, risk tolerances, behavioral finance, high frequency trading, investment strategies and investment objectives iii TABLE OF CONTENTS ABSTRACT ii INTRODUCTION 1 METHODS 5 RESULTS 7 INVESTMENT OBJECTIVES 7 DATA & INFORMATION COLLECTION 9 ASSET ALLOCATION 16 CONCLUSION 26 REFERENCES 31 iv 2 Beginning in the late 1800s, railroad companies were some of the first few American institutions to issue stocks and bonds (Beattie, 2023). These assets were fairly illiquid and were only held by wealthier clients seeking long-term growth, or about one percent of the entire United States population. This proportion would later grow to a high of 10% in the late 1920s due to economic success and larger disposable incomes. According to the U.S. Census Bureau (2021), America’s economy grew 42% in the 1920s. Innovations such as the radio spread information much faster than the traditional newspaper, updating the public with economic or financial news in real time. More than 25% of families had their own car and airplane travel was up 287% (Armadeo, 2022). In 1928, stock prices rose 39% following a five-year bull run that began in 1923. Unfortunately, this long-term market success was severely corrected on October 29, 1929, (otherwise known as “Black Tuesday”), when billions of dollars of wealth were wiped out in a single day, effectively ushering in the Great Depression. This economic decline coupled with a lot of distrust and speculation about the market reduced the proportion of Americans with stock back down to 4.2% by 1952. It wasn’t until 1954 that the Dow Jones Industrial Average recovered to its predepression levels. With the introduction of Standard and Poor’s 500 index (S&P 500) in 1957, mutual funds grew in popularity over the next several years as it allowed a better way for previously hard-hit investors to diversify their holdings (Anderson, 2021). On February 8, 1971, the NASDAQ exchange was launched as one of the world’s first electronic stock 3 markets. These improvements increased investor access to financial markets, raising American participation rates to an all-time high of 15% in 1970 before eventually settling back down to 13% in 1980. The following two decades saw strong economic growth with the S&P 500 increasing 17.4% annually as opposed to its historical 9.7% annual return (Vise, 1989). Despite the political tensions of America’s involvement in foreign affairs, trust in the markets remained high, especially as inflation rates dropped from 15% in 1980 to 3% by 2000 (U.S. Bureau of Labor Statistics, 2021). According to the Economic Policy Institute, it wasn’t until the third quarter of 2001 that the economy experienced its first contraction since 1993 (Weller, 2002). These movements and conditions subsequently increased equity market participation from 32% in 1990 to a high of 60% in 2000. As of 2020, it is estimated that 55% of Americans are invested in stocks. Over time, periods of strong economic growth and technological advancements have proven to increase participation in the market, and the same holds true for our currently young, rising generation. Several new brokerage firms such as Robinhood and Public offer equity and crypto market trading with no transaction fees. The obsession over social media as a news source has increased financial awareness not only for stocks but for alternative investments such as cryptocurrency and derivatives trading. According to Fortune magazine, “Today’s millennials and Gen Z have more economic power than any generation that preceded them. They are earning more, saving more, and 5 cautious risk tolerance. Conversely, most of Gen Z has not experienced financial challenges or investment risks and as such may have a higher risk tolerance. As per FINRA’s 2018 report, parents are engaging in more investment-related discussions with their children than before. While this does not imply a causal link as to why younger people are investing more, it does highlight growing financial awareness among the younger generations. This study will examine whether the young generation’s increased level of participation and investment decisions are demonstrating a higher risk tolerance than those who preceded them. METHODS The younger generations are being brought up in a world of technology. The youngest member of Gen Z was only 10 years old when the first iPhone came out. Information is now available at the touch of a button, and commission free trading platforms make it much cheaper for individuals to invest. Social media has become a powerful tool for information and sharing ideas, especially in the investment space. All of these factors are influencing a generation to act and invest sooner than any that have proceeded them. This research focuses extensively on behavioral finance and risk tolerances between Gen Z/millennials and those belonging to the Gen X/Baby Boomer generations. This will be accomplished by using an investment decision making framework of (1) defining investment objectives, (2) data and information collection, and (3) asset allocation. 6 Investment objectives can be defined as the goals or strategies an investor has for entering into an investment. These goals might include preparing for retirement or saving up to buy a house. Data and information collection is the process of performing technical research and valuations of different investment opportunities that will help an investor achieve their investment objectives. Asset allocation involves buying, selling, and balancing one’s portfolio of assets to maximize returns while reducing risks. A consistent strategy entails aligning all three phases of this process. For example, an investor preparing for retirement may elect for more volatile assets such as stocks in the beginning. As the investor gets closer to retirement, it is generally advisable to move towards safer, less volatile assets such as bonds to create a more stable portfolio value (Beagle, 2023). In this study, we will relate each of these phases between the younger and older generations to observe differences in investment objectives and motivations. This study is being conducted under the hypothesis that young investors aren’t as financially literate as their predecessors and are therefore making riskier investment decisions. Several areas we will investigate for this generational comparison include their trusted or most used sources for financial advice, the length of time spent studying investments, how often they monitor their portfolios/what’s in them, how frequent they trade, and differences in money sources being used to invest. 7 RESULTS Investment Objectives An investor seeking to generate additional wealth through investing will typically do so with an end goal in mind. This can include buying a house, saving for a child’s college fund, retiring or even just to build generational wealth. These incentives often influence the type of assets one should buy and how long to hold them for. For this reason, an investor’s time horizon and risk tolerance are taken into consideration when building an investment objective. The longer an investor has before their targeted return date, the more likely they’re able to benefit or recover from riskier portfolios. As it turns out, every age cohort’s main objective for investing is to eventually retire. A recent 2022 study conducted by MagnifyMoney found that of the 670 investor respondents, 62% of them wanted to retire comfortably. Figure 3 illustrates that although this goal is at a majority across all generations, its prioritization grows the older an investor gets (Cook, 2022). Interestingly enough, the next highest motivation for investing among Gen Z and millennials was to get rich, at 29% and 22%, respectively. 9 These findings suggest that although retirement is of importance to Gen Z, they’re also willing to take a lot of chances and learn through experience. Their relatively young age affords them more time to recover from potential risks, especially as they learn wise investment principles such as the value of asset diversification. Data & Information Collection Gone are the days of reading the newspaper or having to ask your neighbor what they heard on the radio. TikTok, Instagram, Facebook and Snapchat are all the new norms of staying involved and up to date. These free platforms allow users to build a network of trusted family and friends while also exposing them to popular channels or influencers. These influencers have a significant online following and usually gain the trust of those who follow them. Their social status affords them influence on their followers such that they are highly persuasive on things such as purchasing products or making investment decisions. According to a 2021 Motley Fool survey with 1,400 respondents between the ages of 18 and 40, social media ranked as the highest information source for making investment decisions. When asked, “Please select the types of resources used to get information on investing in the past 30 days,” 91% of Gen Z and 75% of millennials selected social media as opposed to 41% for friends and family (Caporal, 2021). Figure 4 illustrates that when it 11 inexperienced investors who might not be financially well off. This leads these individuals to invest on the illusion of getting high future returns even though it’s based off of an influencer’s performance in the past. Take Kim Kardashian, for example. In June of 2021, without disclosing her $250,000 incentive from EthereumMax, Kim promoted their cryptocurrency to her then 220 million followers on Instagram (Sweney, 2022). Sixteen months later the coin had lost 95% of its value and Kim was hit with a $1.26 million fine from the SEC for failing to disclose she was being paid to post her recommendation (Hartmans, 2022). While no one can definitely say whether an investment will be successful or not, popular influencers or celebrities commandeer a lot of trust from the public in what they recommend doing. In terms of the most popular social media sources used for making investment decisions, the same Motley Fool survey found that 71% of Gen Z respondents used YouTube, 42% used Reddit, and 36% used TikTok (Caporal, 2021). Millennials yielded similar results with 52% using YouTube, 36% using Reddit, and 35% using Facebook (see Figure 5). 13 After listening to several YouTubers advocate that Coinbase’s upcoming IPO shares should be valued at $700, Chris convinced himself not to buy, even though shares started trading at only $381. After rising to $429, he started to regret his decision; but once they dropped back down to $333, he said, “I figured I’d be a fool if I didn’t buy. I bought three shares, and I’ve been losing money ever since.” While professional financial advisors can certainly get things wrong as well, Chris’ mistake was getting caught up in the “fanaticism” of YouTube on certain stocks. After he started incurring losses, Chris went back to see just how many of his favorite YouTube channels were right, but not many of them were. “I learned the expensive lesson that these YouTube “experts” should only be watched for entertainment purposes, and that’s about it,” Chris concluded. While Gen Z and millennials are going to more untraditional sources for investment advice, many of them still trust financial advisors the most. According to a recent NASDAQ survey, financial advisors were ranked the highest in terms of trustworthiness (NASDAQ, 2022). Although millennials and Gen Z rely heavily on social media, they trust online forums and podcasts more (see Figure 6). 16 In conclusion, younger investors aren’t afraid to turn to untraditional sources of information for investment advice. While they hold financial advisors as the most credible source in line with other generations, social media remains the highest used source. While the NASDAQ survey did not specify whether the time spent researching assets entailed any sort of technical analysis, young investors are obsessed with seeing how well they’re doing- or how much they’ve lost. Asset Allocation Historical finance classified investment assets as one of three different domains. These included equities, fixed income, and money market instruments. Equity investments, or buying and selling stock, have become more complicated with the introduction of options and derivatives. Options, or derivatives, provide a way to hedge, (or bet), on a stock’s future performance, whether it be an appreciation or depreciation in value. While not specific to equities, the value derivatives are contingent upon the price of the underlying asset or stock, (i.e., your option is only as valuable as the stock price’s movement). Investing in fixed income investments entails buying or selling bonds, or debt instruments issued by companies or the government. United States Treasury bonds are frequently referred to as “risk-free” investments due to a perceived low risk of government default. Corporations and municipalities are also able to issue debt, however, fixed income assets usually don’t yield as high of returns as equity investments due to lower risk of default. In 17 the event of a bankruptcy, debt investors are held at a much higher priority than equity investors, and most fixed income instruments are backed by a specific asset. Money market instruments are short-term assets such as treasury bills, commercial paper, municipal notes, and certificates of deposit (or CDs). These assets are usually purchased at physical locations such as banks or directly from the government entity’s website. Due to the low risk, short term nature of these investment assets, they are also referred to as “cash or cash equivalents.” More recently, alternative investments such as real estate, cryptocurrency, commodities, and derivatives have grown in popularity. Cryptocurrency is a form of digital currency stored by a decentralized system. When Bitcoin, (one of the first cryptocurrencies available), launched in January of 2009 at a price of $0.0008 USD, many people didn’t take notice. It wasn’t until 2011-2013 that the coin started getting noticed, especially as it rose to a price of $64,800 per coin on April 14, 2021. While the rest of the world saw a high value in Bitcoin, several experienced investors did not. Warren Buffet, CEO and chairman of Berkshire Hathaway, (whos portfolio value is calculated at around $299 billion), stated that, “Whether [Bitcoin] goes up or down in the next year, or five or ten years, I don’t know. But the one thing I’m pretty sure of is that it doesn’t multiply, it doesn’t produce anything. It’s got a magic to it and people have attached magic to lots of things” (Macheel, 2022). Many financial experts have argued over the intrinsic value of cryptocurrency or the lack thereof, and while this debate doesn’t fit 19 participating in options is often referred to as a zero-sum game- when one investor wins big, the other investor loses by the same amount. Selling call options in particular can be dangerous for an unsophisticated investor due to the uncapped potential of losses, but this generation has an alarmingly high level of participation in it. Fortunately, however, 30% of Gen Z investors are invested in United State Treasuries, which in some way allows them to buy down some of the investment risks they’re participating in. In terms of equity investments, however, they’re also the least likely generation to use index funds. According to both a MagnifyMoney survey and a Motley Fool study, Gen Z respondents were the least likely to be invested in index/mutual funds at 26% and 35%, respectively (Cook, 2022; Hawkins et al., 2022). Baby boomers were the most likely to be invested at 57%, followed by 38% of Gen X and 31% of millennials (Cook, 2022). A mutual fund is a collection of assets pooled together and sold in terms of shares, allowing investors to diversify idiosyncratic risk in a cost-efficient, hassle-free way. According to data published by the United States Federal Reserve in Figure 10, overall investments in mutual funds have risen at a compound annual growth rate of 16.16% since 2009. The Federal Reserve also provided data for those who were under 40, 40-54, 55-69, and 70+ years of age, wherein they found that those under 40 had the lowest CAGR of 12.18% (Federal Reserve, 2022). While many belonging to older generations are investing 21 Two strategies investors can take are buy-and-hold and market timing. According to U.S. Bank (2020), a buy-and-hold strategy is a “passive, long-term investment strategy that creates a stable portfolio over a long period of time to generate higher returns.” A passive investor will only periodically reevaluate their portfolio, ignoring short term losses for more favorable gains in the long term. A much more active investor participates in market timing, or closely following the market to try and identify bull or bear trends. These investors are seeking above-average returns in an attempt to build wealth quickly. A recent academic article published by Philip Newall and Leonardo Weiss-Cohen highlights the correlation between investor attributes and beliefs to holding strategies. “The two main strands of financial economics,” they write, “both recommend that the average investor should rarely buy and sell stocks, known collectively as ‘trading’” (Newall et al., 2022). Over time, research has found that long-term, buy-and-hold strategies consistently outperform market timing. By investing for the long term, an investor is playing a positive sum game- as a company performs well, profits increase, thereby allowing the company to pass those returns on to investors in the form of dividends or stock price appreciation. When an investor is trying to time the market, they believe that the market is somehow inefficient; that the current price of an asset doesn’t fully reflect its value. By consistently trying to buy at a low and sell at a high, the investor has to be right twice in order to be successful. Newall’s research has found high frequency trading to be more of a zero-sum 22 game, where no wealth was actually created but instead redistributed from the investor who was wrong to the investor who was right. According to a twelve-year timespan of trading data in Newall’s research, high frequency traders were profitable only 5% of the time. While these traders earn above market returns, the chances of success do not favor the average investor. Long-term investing, on the other hand, leads to an average profitability of 10% annually. In terms of investor attributes, Newall found that long-term traders were patient and objective and often focused more on strategic analysis. High frequency traders, however, were overconfident, impulsive, and sensation seeking. One valid concern raised by Newall’s research is the gamification, or “gamblification,” of stock trading, and just how relatable high frequency trading is with gambling. Casino gambling, for example, does not favor the average better in the long term. Significant investments are made by the casinos to get customers to stay longer, knowing full well that a gambler is more likely to lose the longer they play. It is also a zero-sum game- either you win or the house wins. Furthermore, gamblers and high frequency traders have demonstrated similar behavioral patterns. Not only are their attributes similar in terms of overconfidence and sensation seeking but Newall also found that, “People experiencing gambling-related harm usually show signs of behavioral dependence, in that they spend more time engaging in gambling and thinking about gambling than they would prefer” (Newall, 2022). This level of 27 by Ernst & Young found that “70% of women and millennial/Gen Z investors will likely fire their family’s advisors,” especially as they begin to inherit the trillions of dollars’ worth of portfolios currently being held by their Baby Boomer grandparents (Case, 2021). Rather than using financial experts, young investors instead rely primarily on social media and their own analysis/perception of the market when investing. Regardless, younger generations want to take an active approach in managing their financial futures, evident by the extent of time they spend studying potential investments as well as how frequently they check their portfolios. While open mutual funds are simple to access and participate in, it isn’t enough for Gen Z or millennials. These investors want to make asset allocation decisions for themselves and are often persuaded to do so by emotional reason as opposed to logic. Currently, the largest trading platform for Gen Z, Robinhood, is set up to take advantage of their emotions and encourage more frequent participation (Newall, 2022). In conclusion, these motivations and sources of information are encouraging young investors to participate in untraditional or alternative assets such as cryptocurrency. While they’re financially aware of more investment opportunities, they also defy traditional financial principles by taking on debt to invest. Their high-risk tolerance is also illustrated by their high participation in options trading at two times more than the average rate (NASDAQ, 2022). Options trading is something that is recommended only for 28 sophisticated investors who know what they’re doing, many of whom use complex hedges to limit their losses. Do these findings suggest that young investors are investing without merit at all? Is all of their asset allocation or motivations for investing bad? Not necessarily. While Gen Z and millennials are the most likely to frequently trade, they’re also doing the most research beforehand. Based on a millennial report filed by the Bank of America utilizing 1,900 survey respondents, one in four millennials have more than $100,000 in their savings accounts (Pepler, 2021). That same study found that millennials started saving for retirement at the age of 24 as opposed to 30 for Gen X and 33 for Baby Boomers. Their generation was also the most likely to know and understand how capital gains taxes work when they first started investing (Personal Capital, 2021). In the end, Gen Z and millennial investors want a better financial future for themselves, and they’re starting at a younger age to do so. While everyone wants to pick the next Apple or Tesla stock, this generation also wants to be financially independent. Based on the aforementioned Bank of America study, 74% of millennials frequently check their account balances, 55% track expenses, 46% pay their credit card bills in full, 31% plan a budget and 34% of those who do actually stick to it (Pepler, 2021). 29 While gamification elements on trading platforms remains a concern for the Securities and Exchange Commission (SEC), further research has found that investment experience has a negative effect on risk tolerance (Beyoud, 2022). A study conducted by Surabaya State University in 2019 found that while “financial literacy has a positive effect on risk tolerance, investment experience has a negative effect on risk tolerance” (Kusumaningrum, 2019). Their statistical research and findings demonstrate that financially literate investors are more likely to understand the risks of certain assets than inexperienced ones and prepare better by mitigating some of those risks. Investment experience, on the other hand, decreases an investors risk tolerance- especially if that investor learns first-hand just how much risk is involved with investing. With a much larger proportion of young people investing than ever before, their behavior isn’t untypical of an inexperienced investor. Research has found that while they stock pick now, the more losses they incur the more likely they’re going to seek for diversification. Perhaps similar to how a gambler knows ‘when to walk away,’ it will be interesting to see how Gen Z and millennial risk tolerances change as they gain investment experience. In the end, the younger generation is a force to be reckoned with. Innovation and social media have prompted their participation in investing, and many of them are here to stay. The current United States population over 65 years of age is expected to increase to 21.6% by 2040, and as these Baby Boomers begin liquidating their portfolios for retirement, the markets will be even more influenced by the rising generations (U.S. Department of Health and Human Services, 2020). 30 The best thing for us to do, as an investor or not, is to be informed. The world is polluted with information, good and bad, and being able to wade through the muck and skepticism will make all the difference moving forward. 31 REFERENCES 6 reasons to buy-and-hold stocks for long-term investing: U.S. bank. 6 Reasons to Buyand-Hold Stocks for Long-Term Investing | U.S. Bank. (2020, July 28). Retrieved March 26, 2023, from https://www.usbank.com/investing/financialperspectives/investing-insights/buy-and-hold-long-term-investmentstrategies.html#:~:text=Buy%2Dand%2Dhold%20is%20a,them%20despite%20any %20market%20fluctuation. AFREPRELAX News. (2022, September 3). 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