Since March 2020 when we were all locked inside with nothing to do, retail investing has been all the rage. We’ve seen Reddit investors cause hedge funds to lose billions on multiple occasions, teen TikTok traders have become financial “gurus”, and new trading apps like Robinhood have used gamification to explode their user base.
While some of these retail investors have made money, many have seen huge losses because, well, trading is hard work and most people don’t succeed at it. It is widely known in finance that over 80% of traders lose money, but that hasn’t stopped Robinhood from using fun emojis and gamification to keep its users trading on its platform. And the reason they want you to trade more isn’t because they think it’ll make you money, it’s because it’s making them money.
Active vs Passive Investing
Trading is a form of active investing. An active investor’s goal is to beat the market by timing their buys and sales. Active investors will buy a stock when they think it’s undervalued, or trading at a price lower than it’s actually worth, and then sell the stock once the price goes up. The difference between the low price they buy the stock for and the high price they sell it for is their profit.
Traders aren’t the only ones who time the market, though. Many mutual funds are actively managed as well, but instead of trying to make a profit on a single stock, fund managers will construct a portfolio of stocks they believe will outperform the stock market over a certain period.
The problem with both of these active investing strategies is that they usually fail. We already noted earlier that over 80% of traders lose money, but actively managed mutual funds have performed equally horrendously. For nine consecutive years, almost 65% of large-cap active funds trailed the S&P 500. After 10 years, that number jumps to 85% and after 15 years nearly 92% of funds have underperformed the S&P.
Passive investing, on the other hand, just means you invest in funds that track indices like the S&P 500. Based on the stats above, you can see why this is a much more lucrative strategy for investors, so why do companies like Robinhood promote losing strategies to their customers? It’s simple. Because the more you trade, the more money Robinhood makes, all thanks to payment for order flow.
Payment for Order Flow
Payment for order flow is the compensation a brokerage firm receives when they route your trades to a third party to execute. It works like this. You buy 1 share of stock in your Robinhood account so Robinhood needs to figure out how to execute the trade. It is quite complex for a brokerage like Robinhood to execute thousands of trades per day, so they send your trade to a market maker to be executed. The market maker looks for an ask price on the stock you want that is lower than the price you want to pay, or the bid price. Once your trade is executed, the difference between the bid price and ask price, called the bid-ask spread, is the profit for the market maker. Then, as a thank you to the brokerage who sent them your trade so they could make a profit off it, the market maker gives a tiny cut of their profits back to the brokerage.
Since Robinhood makes money on every trade they send to a market maker, they want to keep their trade volume as high as possible to make as much money as possible. This is why they use gamification to keep their users glued to their phones and want to incentivize them to trade, regardless of whether the trade is a smart idea for you or not.
To make matters worse, Robinhood doesn’t need to route your trade to the market maker that is offering you the best price on the stock. Rather, they can route your trades to the market maker that pays them the most for your order flow. So not only are they actively using gamification to get you to trade so they can increase their revenues, but when you do make a trade, they also have no incentive to try and get you the best price on your trade.
What Brokerage to Use Instead
Hopefully, this has convinced you that Robinhood does not have your best interest in mind and that you should definitely switch to a new brokerage firm, but hopefully, it has also convinced you to stop trading. The stats show that the vast majority of traders lose money or underperform passive investments. The point of investing is to make money, and passive investing is the best way to do that.
Use a Robo-advisor
Robo-advisors are one of the most effortless ways to invest passively because they use a quiz to assess your risk tolerance and then based on the results, put you into the investment portfolio that’s best for you. After you take the quiz, the only thing you need to do is keep funneling money into your account.
One of Robinhood’s selling points is that they offer low fees, but luckily for you, so do many Robo-advisors.
Use a Brokerage Firm That Doesn’t Use Payment for Order Flow
If you still want to build your own portfolio, make sure to use a brokerage firm, like Public, that doesn’t use payment for order flow. Public still offers commission-free trading but uses optional tipping instead of payment for order flow to make money.
Public is also doing other things to keep their customers’ best interests in mind. They don’t allow day trading on their platform, which again, is one of the easiest ways to lose money on stocks. They don’t let you trade on margin. They label risky stocks so you know they’re volatile. And more. Basically, they do the exact opposite of what Robinhood does. They put their customers first.
When it comes to investing, the best strategy is the one that makes money. Robinhood has fully adopted that strategy for themselves, but they’ve tricked their customers to do it. They’ve used gamification to promote trading when it’s a losing strategy for most investors, and when they execute those trades, they have no incentive to get the best price for their customers. So it’s time to ditch the tricksters and invest with a better brokerage so you can be the one who’s making the money.