Published February 2, 2021|4 min read
Robinhood was in the news recently for restricting trades of GameStop, BlackBerry and Nokia after investors on Reddit spiked share prices. But it’s not the first time the investment app has drawn scrutiny in the past few months. The Securities and Exchange Commission, which regulates investing, brought charges against Robinhood in December for misleading users on how the app makes money. Robinhood agreed to pay $65 million to settle the charges while admitting no wrongdoing.
Investing apps like Robinhood have become a popular way to invest, but it’s important to understand how they trade on your behalf — and how they make money doing it. Here’s how to protect yourself if you’re using it to invest.
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One way brokerage firms like Robinhood make money is a business practice called payment-for-order-flow. Lex Sokolin, co-head of global fintech at ConsenSys, a blockchain software company, explained this practice:
“Let’s say a client wants you to trade on their behalf. You can send that order and execute in one place or another. The first venue may be paying a little more than the second, so you may send it there. But brokers have to provide their clients ‘best execution,’ meaning that the price a customer gets is the best there is. It is a fine line,” he said.
Brokerage firms must disclose this way of making money to their clients. The SEC says Robinhood engaged in payment-for-order-flow without telling customers.
The SEC also says Robinhood directed trades to venues that paid it the most, rather than those that offered the best prices to its customers. Because of this, Robinhood cost users $34.1 million — even accounting for savings customers get from free commissions on trades, the SEC said.
Robinhood did not immediately respond to an email seeking comment.
Brokerage firms across the country use payment-for-order-flow as a way of making money. Sokolin said it is not a nefarious practice as long as clients understand that’s how the firm makes money. If you’re trading stocks yourself, he warns of apps that may appear free.
“There are always embedded costs somewhere,” he said. “The common criticism is that if the product appears to be free, you are the product. Like Facebook attracts free users for the value of their attention and data, Robinhood attracts free traders for the value of their order flow and market signals.”
Meme stocks like GameStop may sound like a good bet because the internet says so, but they could also be a fluke. When most people think of buying individual stocks, they imagine hitting the lottery. In reality, chances are low that you’ll find an undiscovered company that becomes the next Apple or Google. Here’s our full breakdown on the pitfalls of picking stocks.
Not understanding the way things work could really cost you, said Dan Egan, managing director of Behavioral Finance and Investing at Betterment, another investment service.
“You have to go in with the right mindset. It's like going to Vegas — you go there thinking ‘I'm probably going to lose money, but it'll be fun,’” he said.
There will always be some risk investing in the stock market. The best way to protect yourself when trading individual stocks on apps is investing money you’re willing to lose. It’s also important to do your own research on stocks that get hyped up on the internet.
People are more likely to post their success stories on social media, not their losses, said Egan. “Be aware that when you hear things that are exciting, they are sensational because they are unusual and outliers,” he said. “You need to be a little bit savvy about bias on the internet.”
If you’re looking to invest it’s important to have clear financial goals. Ask yourself how much you’re willing to lose, the returns you want and when you want them. You may want to identify stocks that also align with your moral compass. Egan recommends finding an investment adviser that can work with you to achieve those goals.
“Stock trading for the vast, vast majority of people is risky,” said Egan. “If you want to make as much money as possible, you should invest your money in something that's going to be a low-cost diversified compounding fund. If you keep adding to it, it will grow and compound.”
Image: Upsplash / Vitaly Taranov
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