The late, great John C. Bogle taught us all the importance of managing and minimizing costs when investing. Whether in stocks and bonds directly, mutual funds, or any other type of investment, the price you pay to get it, maintain it and ultimately sell it will have an impact (obviously) on what the total return you earn is.
Bogle wasn’t content to let his research remain in the realm of theory and started putting his words into action. He created the first index mutual fund, which revolutionized investing in large part due to its relatively low cost compared to actively managed funds, which were then the norm. With the new concept of indexing he also launched The Vanguard Group, whose very structure was a drastic departure from industry standards. The company was operated at-cost and all shareholders were simultaneously owners with the goal of constantly decreasing the costs of investing.
Bogle paved the way for other advances in the industry, ultimately ushering in the era of index funds. Others, like Charles Schwab, followed his lead and costs started to drop. The industry slowly started to move towards greater price transparency and commissions paid on stock transactions started to decline rapidly, making investing much more accessible to everyone, not just the wealthy.
Forty-five years after the launch of the first index fund we find ourselves in a world where some investment services, once expensive, or even non-existent, are now at low, or even no cost. One such service currently making waves is a stock trading app named Robinhood.
Robinhood is a relatively new, smartphone-only application, that allows users to trade stocks through a clean, simple and intuitive user interface. Scale Investment Group is in no way affiliated with Robinhood and the thoughts expressed here are strictly our own.
By most measures the app is popular, so popular in fact, that we’ve been asked about it specifically, by name, dozens of times in the past few months. When something captures the attention of so many people, it’s probably best to address it formally.
Of course, application-based trading is not a new concept. Plenty of well-known, well-established brokerage firms have apps through which you can trade securities. What makes Robinhood unique is the trading commission they charge. Zero. Robinhood does not charge a commission to trade securities, and this isn’t a limited time offer either. This is their business model - and for consumers that is a win!
For years brokerage commissions have been declining, getting cheaper and cheaper. When the cost of trading securities was deregulated in 1975, allowing them to be set by the free market, and not by government mandate, commissions started dropping. As more and more investors smartened up and demanded competitive pricing this trend continued over the next 4+ decades through to the present day. Now through the magic of open competition we can buy shares of publicly traded companies for the low, low price of nothing.
We’ve said it before and we’ll say it again - managing costs is a critical component in a successful investment plan. Anyone who says otherwise is either lying or ignorant. After all, paying excessive commissions is like running a race where your opponent gets a head start. The bigger the commission, the bigger the hindrance. The fact that Robinhood doesn’t charge commissions raises the obvious question of how they make money. Robinhood is for-profit entity, so not asking this critical question is a failure in due diligence.
Robinhood makes money from interest on uninvested cash. So, if you have uninvested money sitting in your account Robinhood is collecting the interest. Interest rates are currently low, but they are rising, so chances are you’re not missing out on too much - yet. This is especially true if your account is typically fully (or mostly fully) invested. If, however, interest rates continue to rise and/or your account remains in cash for an extended period of time, that is money you are leaving on the table. Additionally, Robinhood also offers other services, like margin trading or trading through a broker, which are not free.
Robinhood also doesn’t have any minimum account size making it ideal for small investors or those just starting out. If, however, you decide to transfer your Robinhood brokerage account to another firm, be prepared to pay a $75 account transfer fee. These types of fees are not uncommon, but $75 is on the higher end of what most brokerage firms charge.
So far there hasn’t been much to dislike about the Robinhood app. Free commissions are a huge win and if you don’t plan on transferring your account or keeping much in cash then the negatives may not factor into your decision at all.
Our biggest concerns with regard to Robinhood are from their marketing approach. Robinhood markets itself as a trading application, which is what it is. It simultaneously markets itself to a younger crowd and those less experienced with investing. All of this makes sense. Since Robinhood is smartphone based, without a corresponding desktop trading platform (yet) it will appeal disproportionately to younger people who use smartphones for more tasks and with greater veracity. The simplicity of the user interface also makes it much more attractive to folks who are unfamiliar with trading stocks and would likely be overwhelmed with extra trading options, features, statistics and research reports.
At this point you may be starting to see the concerns we’ve identified. Robinhood wants you to think they’re a great stock trading platform for those just starting out, who may want to learn and experience first-hand what it’s like to buy and sell securities, without incurring unnecessary commissions. Simultaneously, it may seem, to those who don’t know any better, that trading is not only fun and exciting, it is also easy and profitable.
While there is no doubt that trading securities can be exciting, and apps like Robinhood certainly make it easy, to suggest, or imply, or even expect profitability is dangerous.
If you fancy yourself a trader, or would like to become one, Robinhood may be the ideal platform, given that costs are zero and everything is available anytime, anywhere through your smartphone. There are no account minimums and no trading fees… does that make it a no brainer?
Since the Robinhood app is marketed to investing novices who may only now be learning the basics about stocks and markets they should probably be informed that trading and investing are not one and the same. These are two very different concepts, with different goals, different time horizons, and much different success rates.
If you’re considering opening a Robinhood account to day-trade with the goal of getting rich quickly, prepare yourself for disappointment and likely failure. Trading is largely an unsuccessful venture – look no further than those who lost their shirts day-trading in the lead up to the tech bubble bursting, or those who didn’t learn their lesson and fancied themselves day traders prior to the housing crash and the subsequent great recession.
Even if you make money trading stocks you have to consider whether you actually accomplished anything or whether you just wasted your time. Earning an 8% return over the course of the year might seem a lot less impressive if it was accomplished at the cost of dozens or even hundreds of hours of effort. This doesn’t even consider taxes, with frequent taxes often come huge short-term capital gains taxes - which will make the 8% much lower on an after tax basis, not to mention the effort to keep all those transactions straight when completing your taxes.
Furthermore, whether 8%, or any return for that matter is good, bad or indifferent, depends on your other options. If you could have earned 10% in an index mutual fund with next to no effort and little, if any, capital gains, you must ask yourself if the time spent trading was worth it.
The reality is that even most professional fund managers underperform their corresponding index over any given time period. The reason is largely two-fold: 1) costs and 2) outperforming is not easy. Yes, Robinhood has no trading costs but regulatory charges still apply and there are other services, like margin trading that are optional, but not free, even if you steer clear of those you could still find yourself paying capital gains taxes and the opportunity cost of time and effort better spent elsewhere.
Perhaps you are the right combination of lucky and smart to beat these professional fund managers, but I wouldn’t bet on it.
While we may be harsh on the concept of trading, the Robinhood app isn’t all bad, and for a select group of people it might even be an ideal tool in their investing arsenal. The type of person who is most likely to benefit from an app like Robinhood is someone who regularly invests in a company, or companies, that they know well, whose business they understand and whose shares they intend to hold for a long period of time.
Since there are no commissions, dollar cost averaging suddenly becomes a practical strategy with individual securities. Holding for the long-term minimizes short-term capital gains and places the emphasis on the long-term where it belongs, not on the short-term as trading suggests. Additionally, and perhaps most critically, any investing done on Robinhood, or any other trading or investing platform, should be done in the context of a well-diversified portfolio.
Robinhood, like many other innovations in finance and investing, is only as good and effective as the strategy it supports. Using it to trade frequently is, more likely than not, to result in underperformance, taxes and often, even losses. On the other hand, using it tactically to supplement a well-diversified portfolio with names that you feel have long-term potential is a much more even-handed and rational approach.
Keep in mind that while the costs of investing have decreased the underlying risk and reward structure of the markets has not. Don’t mistake a rising tide for your own brilliance – measure your performance against the right metrics and take care to invest, not trade so that the odds are in your favor as much as possible. Paying no commissions on stock trades is nice, but it’s far from the only metric to consider, and it’s certainly no replacement for a well-diversified portfolio and a solid long-term plan.