Low-cost stock-trading platforms have been around for years. E*Trade, Schwab, TDAmeritrade. Recently, new apps have popped up that make trading individual stocks even easier, even cheaper (down to “free”), and, I imagine, even funner. Robinhood is a popular one.
The Appeal of Modern Trading Apps
These apps have made investing as prosaic as ordering a pair of shoes from Zappos. From what I’ve observed, these trading apps have a few basic appeals:
- Cost: Robinhood allows you to buy and sell stocks for free. Considering all the talk in the investing universe about the importance of keeping costs low, I can see the appeal.
- User Experience: For a certain subset of tech-savvy folks, the very experience of using these tools is enticement enough. One woman, in fact, told me she started using Robinhood simply because it was a beautiful user experience. What an endorsement of good design, eh? Robinhood is not alone in gamifying personal finance.
Low Cost and Free Are Good. And Can Encourage Exactly the Wrong Behavior.
The point of investing is to fund the future you want for yourself. Be that a certain age for financial independence, the ability to start your own business, leave the workplace to raise kids, or do a certain kind of travel.
If you’re not funding the future you want, you’re not investing, you’re playing (gambling, speculating, take your pick).
The most important parts of a successful investment approach:
- Keep costs low.
- Diversify (own a little of everything, instead of a lot of a few things).
- Ignore your investments most of the time.
So, I am delighted (delighted!) to see the costs of investing trending ever downward. I take advantage of that myself in my practice, investing clients’ money in low-cost mutual funds and exchange-traded funds (ETFs) that are usually free to trade. Empirical studies and academic research have shown time and again the outsized importance of low investment costs.
The mutual-fund-research giant Morningstar released a study in 2016 showing that “The expense ratio is the most proven predictor of future fund returns.” And while we’re talking about individual stocks here, not mutual funds, the logic is the same: the less you pay to own your investment, the more of the return you get to keep for yourself. It seems that message has finally hit the popular zeitgeist.
These trading apps are hitting their “free” message hard. But I am afraid that this free-ness encourages two outright dangerous investing behaviors:
Danger #1. Investing in individual stocks in the first place.
It’s difficult to get the kind of diversification from owning individual stocks that you can from owning broadly diversified funds. And that level of diversification can drastically lower the risk of loss.
Danger #2. Buying and selling frequently.
If it’s free to trade, why not do it every month, every week, or even every day?
Because study after study has shown that the more you muck around with your investments, the lower your returns. This is, in fact, one of the reasons women tend to make better long-term investors: they consider investing less of a competition and so let their investments ride.
Many financial advisors encourage you to not even look at your investments more than once a year. Because looking at your investment makes it more likely that you’ll want to change them. And change, in this case, is usually bad.
So, while the obvious, direct costs of trading in these apps might be free, losing the money you invest in the stocks is most definitely not. When the stock you chose loses half its value, will it be so much comfort to you to know that you didn’t pay a nickel to buy it? I doubt it.
Trading on Margin at Robinhood
I admit I hadn’t thought much about these apps until a recent conversation with a prospective client. She uses Robinhood, and I asked whether Robinhood had figured out how to make any actual money, as it literally had no source of revenue, last I heard.
Oh yes! she informed me. You can now pay some amount of money a month ($10/mo, $40…something in that range) to borrow money from Robinhood and invest that borrowed money.
I couldn’t believe it. Robinhood’s bid for profitability (hell, for any revenue at all) depends on its customers trading…on margin?
Margin trading allows you to significantly amplify the results of your trading, both for the better and for the worse. Here’s an example of how margin trading works. You pay $10/mo to Robinhood to borrow $2000 to invest.
- In Scenario 1, you choose your stocks well. That is, you’re lucky. That $2000 turns into $3500. You sell the stock and pay back that $2000 to Robinhood. You’ve turned $10 of your own money into $1500. You are $1490 richer. Quite the return!
- Now, let’s investigate Scenario 2, which I will dub the Scenario of Sadness. This time you choose unluckily, and that $2000 investment loses most of its value, and it’s now worth $500. You sell the stock and have the $500, but you have to return the full $2000 to Robinhood. Now you’ve turned an initial $10 investment into a negative $1500 return. You are out $1510.
Turning $10 into $1500 is great. But that potential doesn’t exist without the equivalent risk on the downside.
And I am downright scared that many people are not going to understand, truly understand, the potential impact that Robinhood’s margin-trading “feature” can have on their finances. It is way too easy to lose a lot of money trading on margin. And it is way too easy to trade on margin with Robinhood. In this case, the transitive property is definitely not your friend.
As much as I think trading in individual stocks is unnecessarily risky, at least you can only lose the money you have invested. With margin trading, you can lose a bunch of money you don’t have. Think about that, eh?
If You Really Really Want To
If you cannot escape the siren call of Robinhood or similar apps, fine, go ahead and carve out a chunk of “play money” to trade. But make sure that you are perfectly okay with the idea of losing every dollar, and that losing it won’t jeopardize your financial security.
There is an entire industry of highly paid professionals with vast resources at their fingertips spending all day every day choosing stocks to buy and sell. The likelihood that someone whose day job is full-stack engineer or UX designer or community manager is going to do better than those stock professionals is, well, what do you think about your chances?
There are plenty of things in your financial life and your life in general to get excited about, to turn into a game, and to work on every day. Investing shouldn’t be one of them.
Sign up for Flow’s Monthly Newsletter to stay on top of my blog posts (and the occasional video), and also receive my guide How to Start a New Job (and Impress Yourself and Everyone Else) for free!
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Meg Bartelt, and all rights are reserved. Read the full Disclaimer.