How will Robinhood affect your returns?

Robinhood is definitely a cool app. It is one of the fastest-growing apps these days, and when taking into account its particular field of financial services, its growth is even more impressive. Robinhood is a financial services company showing growth similar to that of an internet services company, with over 140K new subscriptions a month, and 17% monthly growth to their premium subscription.

Robinhood is a disruptive company. It allows people to trade stocks with no fees. With this simple, yet genius pitch, they have penetrated the fortress of the financial services industry as part of the trend over the last few years of start-ups trying to disrupt the large financial industry. Like some other FinTech companies, Robinhood is trying to use innovative technology to change standard financial procedures and accelerate others, but the company has some distinct differences from other FinTech companies because it changes our incentives.

Inside our mind

I like disruptions, especially in markets that haven’t seen significant changes for a while. When I first heard of Robinhood, I was amazed. I was (and still am) not sure that their business model is sustainable, and I suspect they lose a lot of money, but the idea of taking no fees for trading stocks sounded simple and even a stroke of genius. Like some other unicorns (start-ups valued at more than $1 billion), they have a very clear and easy-to-understand business model, and you wonder why such a company hasn’t been around before now. They also really understand the millennial mindset, and many first-time investors have joined the market thanks to them.

Robinhood has shown that it can partially solve the problem I discussed here—millennials staying away from the market. It allows young people who do not have an investment account to easily invest and can hypothetically allow those people to generate massive returns, as no fees are deducted from their trades. But can these hypothetical returns turn into actual returns? This seems unclear since the no fees policy incentivizes investors to be more active in the market rather than the way they would act if they are subject to fees.

While we consider whether or not we should buy a new stock or sell one we already own, certain factors may affect our decision, some of which are endogenous to the company and several others that are exogenous and related to our personal financial tastes and preferences. The first could be our analysis of the company or other analysts’ opinions; the trend in the market can also make a difference, while exogenous factors can relate to our liquidity needs, aversion to risk, and other things we want to do with our money.

Another factor that affects our decisions in the stock market is the fees we are paying. Until Robinhood became part of our life, every trade or action in the stock market had a cost, and fees accumulate and have a major impact. For example, think about a person who’s investing $100,000, with an average return of 6% annually. He has to decide between two investment accounts—one will cost approximately 0.5% in fees annually, and the other will cost approximately 1%. This difference doesn’t seem significant, but for the first option, this person will have $841,700 after 40 years (yet again, the pure joy of compounding), whereas, for the second option, this person will have only $688,100. So, it’s a difference of over $150,000, which is caused by just a small difference in fees.

As the period of investing becomes longer, fees take a bigger share of your money (not only in absolute figures but also as a percent of the money).

But . . . maybe fees are not all that bad?!

So fees can hurt your return badly. I would certainly acknowledge this fact and advise in favor of any financial vehicle with fewer fees (if you still haven’t read my post on ETFs, now is the time). In the last year, however, while watching people using Robinhood and I had a Eureka moment. Maybe fees are not all that bad! Fees incentivize you to take fewer actions in the market. You would not buy and sell on a daily basis if you were aware that each trade would cost you well-earned money and decrease your return. With Robin Hood, though, it doesn’t decrease your return. Or maybe this is what you believe . . .

One bad market practice that can be more costly than paying fees is trading too much.  The average investor cannot time the market and definitely cannot time the daily performance of specific stocks in the market. Regular investors are sometimes biased to make trades that are not based on economic analysis, for instance, buying a stock only because it is relatively down and seems to be a good price or selling a stock that has made some gains from the purchase price. These decisions are usually wrong, as in most cases stocks on the rise will continue to rise, while stocks on the way down will continue to fall.

A worse recipe for hurting returns is a mix of negligible trading cost and panic in the market. Robinhood didn’t even exist in times of financial crises, but we can try to imagine what could have happened if it had been. History tells us that the market can lose considerable value even in one day, but many black days in the market have been followed by some very green ones. Many average investors, however, panic in the black (or red) days and sell their stocks. By doing so, they lose the gains of the next day. Some of the largest losses in the market have been followed by major gains.

Moreover, research has shown that long-term investment is the most profitable form of investment for the average investor. How does a zero fees policy affect investors’ tastes? Consider the following:

  • The investor would tend to sell rising stocks
  • The investor would not want to sell declining stocks since he wants to return to the principal amount, unless they fall really hard
  • Investors would be tempted to take more risks in the market since he can still sell the stocks in time

All of the above can easily be catalyzed by Robinhood—not because it is not a great app, which it definitely is—but only because people respond to incentives and Robinhood changes the way we think in the market.

The bottom line

Robinhood is a game changer. It communicates the market to a new population and mainstreams the market among millennials. Also, no one wants to see the big brokerage firms making more money than they do now, so a brokerage firm with no fees is as close to utopia as it gets. We just need to be very aware of our behavior in the market. We need to understand that we need to pay lower fees but act as if we are paying higher fees, which means looking for long-term value investments and not day trading just because no fees are required. Intuitively, I’m afraid that it’s the other way around with Robinhood, but its history is too young to be analyzed completely as yet.

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