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Getting young people investing is a good thing, if done right
Robinhood has brought a large amount of people into the market and made investing less intimidating. However, with the recent announcement of a $65 million settlement being paid to the Securities and Exchange Commission (SEC), it is worth looking at Robinhood again and why some things about the online brokerage should concern investors.
- Robinhood has helped bring new investors into the market through an easy-to-use app and a no-fee approach.
- The company has run into controversy for building its payment for order flow (PFOF) into its largest revenue driver.
- Although PFOF is concerning, the way Robinhood has been gamifying investing may be the more problematic issue in the long run.
A Slick App, but a Mediocre Online Brokerage
Although it may sound harsh to many of the users who love investing through Robinhood, it is far from the best online broker out there. Robinhood’s app is easy to use, and its commission-free trading was once a bold statement, but the rest of the industry has moved away from commissions and fees as well. The attractiveness of the app owes largely to its simplicity, removing a lot of clutter from the trade experience. Unfortunately, this also means less information and tools to help inform investment decisions, meaning that motivated beginners will outgrow the app as they become familiar with the market.
Were that the only knock on Robinhood, it would stand up as a decent entry point for novice investors to get into the market mostly on the strength of the usability of its mobile app. The tools, data, and educational resources aren’t exactly up to the level you would want for a service looking to fill a niche as the first step into the market, but that may improve with time.
However, that is not the only knock on Robinhood. We often go after platforms aimed at investors that hide their true costs, and Robinhood is no different. PFOF is something we’ve drawn attention to many times, and this is going to be important when evaluating online brokers going forward because most online brokers have joined the no-fee movement.
Payment for Order Flow at Robinhood
In reality, the no-fee movement may end up being described as a no-explicit-fee movement, as the payment for order flow revenues have grown at many of these firms. Not to rehash the whole argument, but investors trading at firms with higher PFOF are paying a hidden fee in terms of poorer execution on their trades. This means that they may pay a higher price when buying or get a lower price when selling than they would with another broker less focused on PFOF as a revenue generator. For buy-and-hold investors making only a few trades a year, PFOF-related slippage may not be a huge burden, but it is a bigger issue for more active investors and traders.
Of course, it is PFOF that resulted in Robinhood paying out $65 million, as the SEC estimates that Robinhood’s poor order execution cost its customers $34.1 million between 2016 and 2019.1 Robinhood also appeared to be hiding the fact that PFOF was its main way of making money, which is really the part we at Investopedia took issue with. The sad thing about fees vanishing is that analyzing the fees previously made it transparent for investors looking to compare the online brokerages quickly. You look at the fee; evaluate the tools, services, and data that you intend to use; and then decide whether it is worth the cost.
Some firms have been good about making their PFOF activities explicit in disclosures, providing a clear picture of how much it represents as far as revenue. This helps investors gauge how much of an issue it is likely to be. Others have explicitly stated that they do not and will not engage in PFOF. Having to dig through disclosures to find this out, however, is a more involved task than a simple scoring table based on fees and features. This means that some of the stuff buried in the disclosures will be missed by new investors and even some of the sources they are going to for high-level reviews. That said, more transparency can be expected on PFOF, especially when settlements start piling up for the SEC on this issue.
Robinhood and the Gamification of Investing
The most problematic thing about Robinhood isn’t the payment from order flow. Robinhood’s chief legal officer stated that the historical practices that got it in trouble with the SEC aren’t happening anymore. (Investors will want to confirm this in the PFOF figures.) The bigger concern is around the gamification of investing – something Robinhood pioneered and is currently doing better than anyone else.
Gamification is a powerful tool, and it can be used for good in getting you to exercise more, eat better, save more, and so on. When these nudges, notifications, achievements, and other psychological tools are turned toward investing, however, it erases the already thin line between playing the market and playing the slots.
Robinhood makes investing exciting and, arguably, has some design elements that seem to be encouraging more rapid trading than a buy-and-hold approach. The Massachusetts Securities Division appears to be ready to make this exact case.2 Trading, and even high-volume trading, definitely has a place in the market, but it is also something most people would agree shouldn’t be encouraged for investors just starting out (more trades = more PFOF).
The Bottom Line
Bringing young investors into the market earlier is a positive thing, but it has to be done right. Young investors benefit from a long investment horizon over which to learn and hopefully profit, but they need knowledge as much or more than they need a streamlined trading experience.
Robinhood’s methods right now do seem to stray into a dangerous area by turning stock trading into an addictive game. However, as a young company, Robinhood has the time – and one would assume the user data – to look at its app and curb the features leading to some of these stock trading horror stories. As it stands right now, however, it is difficult to recommend Robinhood to new investors, but that hasn’t stopped millions of them from finding it on their own.