TL;DR

[TL;DR = Too Long; Didn’t Read. That is, it’s the executive summary]

• Robinhood.com makes buying and selling stocks cheap
• Single stocks are risky
• You can use Robinhood to trade ETF mutual funds
• Accounts are non-tax-preferred
• Don’t trade on margin
• Don’t invest if you’re in debt now. Pay off debt. Invest later.

Normally if you want to buy and sell stocks, there is a fee associated with the trade. If your transacting a high dollar amount, the fee is a small percentage of the trade. But if you want to buy say one share of one company, the transaction fee may be a significant percentage of your cost. In fact, it could exceed the cost of the stock if you’re buying a low-value stock. As of this writing, the popular trading platform eTrade costs $6.95 per trade. So, if you bought a share of DropBox for $21.24, and then decided that was not a great choice and sold it, you’d rack up $13.90 in fees. Ouch.

So, along comes Robinhood.com. They decide to change the business model somewhat. They basically did away with all the human sales staff, and went computer-only. Actual day-to-day trading is basically all handled by computers anyhow. (In fact, many trading firms make it a point to have their computer data centers physically close to the stock exchange’s data centers, so that the speed of electricity will not be a limiting factor in the speed of their trades.)

So, Robinhood dropped the fee for stock trades from around $4 – $10 from other vendors down to $0. Of course, Robinhood is not in the business of not making money, so, they make money a few ways:

• They make money on the uninvested cash deposits of investors. Most investors have at small amount of cash in their account. Robinhood does not pay interest on uninvested cash, but they almost certainly are earning interest on these deposits.
• They receive payment for order flow. Basically, high-speed trading organizations can fulfill stock orders in a manner where they stand to make fractions of cents per share. The high-speed trading organizations pay retail firms, like Robinhood or eTrade for the right to fulfill their customer’s orders. This is standard industry practice, and is legal as long as you’re being quoted the best available price.
• They have premium accounts.

So, they probably make less per customer than many other brokerages do, but they make up for it in volume and automated customer servicing.

Robinhood is a member of SPIC, which insures that if Robinhood fails, you’ll still own your stocks and uninvested cash.

So, the big downside with Robinhood is that it makes it easy to invest in risky single stocks and lose a significant portion of your money. It’s hard to predict which stocks go up and down, so if you have a stock portfolio with a lot invested in a single company, if that company goes bankrupt, you’ve just lost a huge amount of money. (Enron comes to mind, as does Helios and Matheson.) Also, many trading tendencies lead people to buy high and sell low. You get caught up in the enthusiasm as a company is prospering, buying high, and then panic when a hiccup comes along and sell low. Ouch.

The other big downside for many investors is that they currently don’t offer any tax-favored accounts. Accounts like a traditional IRA or a 401(k) allow you to give tax-savings this year for amounts invested. Accounts like the Roth IRA or Roth 401(k) don’t offer tax-benefits this year, but promise that you will not pay taxes on the growth when you withdraw it. Any earnings from your Robinhood brokerage account will be taxed. I imagine that Robinhood will eventually offer tax-favored accounts, but that’s not a current offering.

Also, Robinhood has the “Robinhood Gold” account for a monthly fee. The Gold account lets you buy on margin. What’s buying on margin? It means borrowing money to buy stocks. Do not borrow money to buy stocks. It is a horrible idea. Borrowing money on margin to buy stocks is the easiest way to lose 100% of your invested money. Stay far away from the Gold account.

So, what is Robinhood good for? Well, it is a useful illustration of how the stock market works. Mutual funds are by far the best way to make money from the stock market, but they can have the effect of making it less clear how the stock market actually works. To help my kids understand the nature of the stock market, I put a very small percentage of my net worth into a Robinhood account and bought a handful of stocks of local companies and companies we’ve done business with. So, now we can walk into a number of local stores and know that we are part-owners of the operation. We also get notifications to vote at shareholder meetings. And for most older companies, you also receive a quarterly dividend payment from the company. So, it helps make sense of why stocks have any value and it’s not just a game of hot-potato. The value is that you get a share of the company’s profits and you can a vote in some decisions of the company.

The other thing it can be good for is investing your non-tax-preferred investments in exchange-traded mutual funds. In most cases, most people will want to do investments in tax-preferred accounts, like 401(k)’s, IRA’s, ESA’s, 529’s, HSA’s, etc, which Robinhood does not offer. However, there are cases where it might make sense to invest in non-tax-preferred accounts. With Robinhood, you can invest in mutual funds that are traded on the stock exchange. For example, Vanguard has a fund that tracks the S&P500 sold under the symbol VOO. You can buy this on Robinhood, and the minimum investment is just the cost of one share. ($265 as of this writing.) Many mutual funds have a multi-thousand-dollar minimum investment for non-retirement accounts.

So, Robinhood is not a scam. However, for the bulk of your money, put it into boring mutual funds and leave it alone. Also, if you’re in debt, don’t be investing – pay off the debt. You get a double benefit for paying off debt – you get a guaranteed return in the form of saved interest, and on top of that, you’ll be reducing your risk.