By Robert Toomey, Special to the Reporter
Several weeks ago Barron’s (financial) Magazine ran a story about Robinhood.com.
Robinhood is a new free online securities trading platform. It has attracted a lot of “clients” that tend to be trading-oriented, and many of whom are millennials.
Don’t get me wrong, I think it is great that millennials are increasing their knowledge of investing (and saving) and that a free trading platform such as Robinhood enables them to do this in a low cost manner. However, there are elements of Robinhood that raise concerns about not only the risks these people may be (unknowingly) taking but also about increasing risk for the stock market itself.
Lest one be fooled by its name, Robinhood.com is hardly the kind, 12th century altruist taking from the rich and giving to the poor. The founders of this company are tech entrepreneurs using advanced technology to create a business.
That’s great, but the problem is Robinhood is paid primarily based on order flow (to floor trading operations on the stock exchanges). This is an inherent conflict of interest: by encouraging high volumes of trading on its platform, it actually increases risk for its customers and can actually work against the important principal of long-term investing.
Second, the platform may be encouraging many people who have no experience in investing to make risky bets on stocks about which they know very little. Not only is this a risk for these individuals but also, it has some of the earmarks reminiscent of the dot com bubble of the late 1990s and may imply increasing frothiness in the stock market.
Remember in the late 1990s the plumbers and dentists giving up their “day jobs” to sign up with day-trading firms? Most of them lost their shirts. The high volume of trading in high risk stocks at Robinhood may be a sign that stocks, or at least certain sectors of the market, may be overvalued.
Why? Because it reflects the fact that speculation may be high, like it was in the late 1990s. Does this mean we are on the verge of a market crash? Not necessarily, but it may be a sign that valuations are stretched and that it may be time to take some risk reduction measures in portfolios.
Despite advancements in financial technology, investment fundamentals have not changed: it is important to understand what you own and understand how to manage risk in portfolios.
The concern with Robinhood is that many of these people do not truly know what they own or how to manage risk in portfolios and could get really hurt in a serious market pullback.
Some of the best ways to manage and reduce risk in investment portfolios are through asset class diversification (owning stocks, bonds, real estate, etc.), working with a financial planner to determine one’s optimal allocation, and having the discipline to maintain that allocation through all types of markets, both up and down.
Robert Toomey, CFA/CFP, is Vice President of Research for S. R. Schill & Associates on Mercer Island.