Is Trendy App Too Targeted on Short-Term Investing?

My $200 account on Robinhood went down by 7 cents today. I’m in a cold sweat. I have two decades’ experience in the markets and teach investment management at a state university. Now I’m reduced to obsessing over moves I might make to reverse that wretched 7 cent loss. If this roller coaster is any indication of how Millennials and Generation Z invest in the market, we have some work ahead of us. Investing doesn’t have to be and shouldn’t be this stressful.

A few industry veterans still remember May Day of 1975, when stock commissions changed from a fixed schedule to commissions set by competition. Industry pioneer Charles Schwab led the foray into discount brokerage, offering lower commissions for do-it-yourself investors. Since then, as we all know, investing costs have been on the decline. And, thanks tothe internet, information once solely available to professionals is available to almost everyone.

Now there’s a new wave of discount financial services that are going even further than Chuck Schwab. These brokerages don’t charge commissions and allow beginning investors to start without a substantial deposit. They don’t trade in shares; they trade in dollar amounts and fractions of shares while still obtaining timely executions.

The industry leader of this next wave of financial services is the privately held broker Robinhood. To learn more about this wildly growing platform, I opened a small account and took a stroll through Sherwood Forest to see what exactly Robin has in his quiver. Joining Robinhood in its quest to rob fat cat larger brokerage firms of clients are the Merry Men competitors such as Stash, Acorns and roboadvisor firms like Betterment that manage your money for you.

 

Making Investing Easy and Fun

Robinhood offers a dramatically different user experience tailored to younger investors when compared to traditional online brokerages. Much of its appeal centers around an attractive interface and instant service. If you use the app to initiate a cash transfer from your bank, you won’t need to wait for it to clear your bank. Robinhood can instantly credit the account, up to $5,000.

It’s also upbeat. It minimizes all the dry disclosures and maximizes emojis to the point where I felt like I was using a self-affirmation app. Almost every action I took, from opening the account through funding it and buying a stock (well, a fractional share), was acknowledged with a colorful emoji and exclamation point. That’s a growing trend. Online insurance providerLemonade also makes getting a home-owner’s policy an emoji laden event.

Robinhood offers one free shareof stock when you open an account and another if you refer a friend. Immediately after opening my account, I “won” one share of WPX Energy (ticker: WPX), a $3.4 billion energy exploration company re­cently trading at around $6.00 per share. You won’t get to pick which stock you’ll receive. There’s a 98% chance the granted stock will be worth between $2.50 and $10. The highest price share will be up to $200. Other firms use different strategies to buy your loyalty. For example, Acorns ties in with major retailers to offer you bonuses when you spend money.

 

Commission-Free Investing Explained

Robinhood can offer commission-free trading through economies of scale and payments for order flow. Order flow is the volume of trades directed to a broker who might be able to earn money on the trade. Regulators have worked to make sure this practice is disclosed to clients and doesn’t affect the quality of the trade, meaning the client will still get an attractive price when buying or selling stock. The smaller the order, the more impact a fixed commission has on returns.

Robinhood also offers additional data and other benefits through its Gold program for $5 a month. According to a recent news release, the firm is growing like fire. The number of revenue generating trades doubled from the first quarter of this year to the next. Not surprisingly, this allowed the firm to raise additional capital at a higher valuation. As of the last funding round, Robinhood’s valuation was north of $11 billion.

There are three ways the company can grow its revenue from that vital order flow. It can attract more clients, encourage its clients to trade more frequently or it can steer clients toward securities that generate higher payments. Option trades generate more money for Robinhood than buying and selling S&P 500 stocks. An option trade can be worth around four times as much as a stock trade to the brokerage firm, but if the same amount of money gets invested in options instead of stock, the revenue could be multiples of that.

That might explain why it is so easy to open an option account. I was able to do just that with only that $200 deposit, entering in very typical net worth and income figures, and checking a few boxes declaring myself an “expert” with a desire to speculate. The risks of option trading (and there are many) were easy to miss when opening an account, and, once my profile was enabled for options, the option trading button is hard to ignore.

That user experience seems perfectly designed to tempt investors into short-term trading. The app opens with a chart showing how your account is doing that day. Though you can tweak the page to see your account performance over longer time horizons, you have to manually change that each time you open the app or the website. There’s no option for your home page defaulting to, say, a monthly or annual view that truly reflects whether you’re making progress toward your goals or at least beating a benchmark. The first view always seems to be how you are doing for the day.

Thus, my cold sweat. I am down by 7 cents, and Robinhood won’t let me forget it.


What the home page does offer are lists. Those lists include cryptocurrency, cannabis, the most popular stocks and top movers, along with the more standard fare of industries and sectors. There’s nothing wrong with offering ready-made screens. We all need sources for ideas. But there’s little encouragement for clients to do additional research into the company or consider how buying that stock will affect the risk of their total portfolios.

That apparent emphasis on short- term trading has driven criticism that the platform contributed to a 20-year-old client committing suicide over what he thought was a $730,000 loss. Though it’s not certain, he may have simply misunderstood how options work. The firm didn’t have a spokesperson available to comment for this article, but Robinhood’s executives told Barrons for an Aug. 16 article that they are seeking to add educational tools, and it’s not their responsibility to police clients who presumably should know what they are doing. Robinhood’s executives have consistently argued the brokerage gives small investors access to tools they say were previously available only to larger investors.

That might prove to be a shortsighted view. Lawmakers and regulators are beginning to warily examine Robinhood’s hands-off approach and re-examine precisely where a client’s responsibility ends and the firm’s responsibility begins. There’s a good reason for regulators to be concerned. Robinhood has spawned a passionate and vocal client base that’s reminiscent of internet stock chat boards in the late 1990s.

Interested BetterInvesting Maga­zine readers can go on Facebook and find groups devoted to discussing Robinhood stock picks. With some rare exceptions, there’s a ton of enthusiasm and little careful analysis and discussion.

As this article was bring written, Tesla (TSLA) was the darling of the moment. It was discussed to the point of beginning to look like a feedback loop. Posters were enthusiastic about TSLA because it went higher, which led others to believe the buzz would drive the stock even further, regardless of what the fundamentals might indicate. Once the buzz dissipates, the stock collapses. Unfortunately, bubbles are very difficult to spot, except in hindsight.

This sort of social investing makes stock fraud a piece of cake through what’s known as “pump and dump scams.” Savvy fraudsters first build positions in penny stocks, start rumors to drive prices up and then dump their positions at a profit, leaving victims with worthless positions. But these comments do offer opportunity. They give more sophisticated investors a better idea about sentiment. We can follow these threads and use them for contrarian ideas, provided we can live with all the hyperbole as well.

 

Robinhood may have played a bit fast and loose with required disclosures, too.

 

The Wall Street Journal reported on Sept. 3 that until 2018, the firm allegedly neglected to inform clients it sold order flow to electronic traders. If true, that could have represented a potential conflict of interest with the broker’s obligation to pursue best trade execution for its retail clients.

 

Will the Next Generation Abandon Stocks?

Most day traders fail to make money. Some lose all or most of their capital. One concern about Robinhood and firms like them is how reliant they are on bull markets. When the stock market plateaus or plunges into a prolonged bear market, Millennials and Gen Z investors may attribute their losses to being unlucky or associate stocks with gambling instead of not having acquired the skills and patience of long-term investors. Rampant speculation preceded the market crashes of 1929 and 2000.

There’s more buzz surrounding Robinhood today than ever, but there isn’t nearly enough thought about how alienating a generation of investors might impact the economy. We should know better. Economic history is full of lessons on the dangers of speculation. We’d do well to heed them, if only to avoid having our kids live with us for the rest of our lives.

 

Fintech Advance or a Bubble Machine?

Innovative technology, enlightened regulation and robust competition have made investing accessible to more people than ever before. Robinhood offers a valuable service by making it easy for people to begin their investing careers with fractional shares and zero commission trades. But investors’ passions also need to be matched up with educational opportunities.

Robinhood is some slick software and it’s hard to beat the free commissions. Their posted margin rate of 5% (for Robinhood Gold members at $5 a month) is also signifi­cantly less than rates recently offered on TD Ameritrade, both as of late August. Some BetterInvesting members might be able to distance themselves from Robinhood’s circus-like atmosphere and might appreciate the lower costs. Traditional online brokerages offer much more information and investor education and, for that reason alone, might be worth the slight premium requested.

If Robinhood continues to promote carefree fun instead of a more sober approach to building wealth, we BetterInvesting members have an important job to do. We must encourage the next generation to stay invested long enough for basic investing principles to win out over random or short-term fluctuations.
   

Companies mentioned in this article are for educational pur­poses only; no investment recommendations are intended. Readers are urged to conduct their own studies of any stocks of interest. This article was originally published in the November  2020 issue of BetterInvesting Magazine.

Sam Levine is a frequent contributor to BetterInvesting Magazine. He teaches securities analysis and portfolio management at Wayne State University. Sam Levine does not own shares in any stocks mentioned in this article.

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