Common pitfalls for new Robinhood users

Robinhood’s latest announcement that it will actively recruit college students to use its platform via cash prizes highlights the importance of providing young people more access to modes of investing–if they are well informed.

What once required an investor to have over $100,000 in assets and a broker to place all trades for them, now takes a few simple clicks on a free phone app. Students as early as high school can place life-altering trades in seconds.

This can clearly cause problems for those unfamiliar with the risks in these markets and not privy to best practices on how to gain long-run returns while minimizing pitfalls. However, the solution isn’t as simple as opposing this move by Robinhood. On one hand, getting young people to invest early and experience how the power of compound interest is one of the greatest things that can lead to long-term wealth. Transaction costs are the lowest they have ever been for investing and access to markets is easier than ever–all great news for starting investors.

Students need to be aware of how to use this opportunity to build wealth at a young age, without being taken advantage of by Robinhood and other broker-dealers.

First, young investors should be aware that Robinhood’s business model is built upon getting you to trade as frequently as possible. To do this, they have structured their app to “gamify” the process of trading, taking advantage of those who are prone to risk-taking behavior and making the trading process seem fun. The more one trades on the Robinhood app, the more it makes, and the lower one’s long-run returns will be.

Next, young investors need to understand the concept of “payment for order flow.” In essence, it may look like one is paying nothing to transact on this app, but in reality, every time one trades, they are getting the worse of two prices in the market. When buying, they are paying a slightly higher price than other institutional investors, and when selling, they are getting a slightly lower price than other institutional investors. Unbeknownst to app users, each trade placed has a hidden fee of taking the worse of two market prices.

Finally, while stock markets are a great tool to access early in life to build wealth, other markets —like futures or options markets–will destroy the amateur investors’ savings the more they engage with them over the long run. We know that stock markets have delivered the average investor approximately 10% per annum over the past decade. Options markets have an expected return of 0% by definition. To make it worse, the hidden transaction costs of being on the other end of the trade in the options markets are far worse than in the stock market. While an investor may lose a fraction of a percent paying to transact in the stock market, in the options market an investor can lose 5% of their investment on every transaction. Therefore, an investor that puts their money in the stock market will always outperform an options market investor in the long run.

When all is said and done, a disciplined young investor can still benefit from this low-cost environment offered by Robinhood if they play their cards right. If one can restrain themselves to put in an equal amount of money each month to equities in the market, not trade too frequently, and avoid exotic markets like options or futures, then it will be the young investor that comes out far ahead in this relationship with Robinhood.

Derek Horstmeyer is a finance professor at George Mason University’s School of Business who specializes in corporate finance with research on ETF & mutual fund performance, ESG investing, and boards.