: Robinhood wants to give first-time traders investment advice. Should you take it?
Robinhood is looking to educate novice investors on the first steps they should take. But financial experts argue that people just starting off on their financial journeys should proceed with caution when using investment apps.
On Tuesday, Robinhood HOOD, -2.47% rolled out a new service called “First Trade Recommendations” aimed at first-timers just breaking into the investing landscape. The service “allows customers to learn by doing,” the company said in a blog post.
New customers will be given an option to receive help investing. When they click on that option, they will be directed to fill out a questionnaire about their appetite for risk, their investing goals and how long they plan to be investing.
It will produce personalized portfolios, featuring four exchange-traded funds, based on algorithm utilizing the responses received through the questionnaire. “The recommended ETFs will give customers exposure to a diverse set of domestic and international equities, as well as exposure to the U.S. bond market,” the firm said.
The ETFs are spread across four asset classes — U.S. equities, developed market equities, emerging market equities and U.S. bonds — with one ETF being assigned for each class.
Not everyone believes Robinhood’s recommendation system is necessarily a good idea. “A broker is not normally considered a fiduciary — that is, someone who must work in your best interest,” James Royal, principal reporter at Bankrate, told MarketWatch.
“‘My biggest concern with a program such as this is whether Robinhood must act in the interests of its clients and to what extent.’”
— James Royal, principal reporter at Bankrate
“My biggest concern with a program such as this is whether Robinhood must act in the interests of its clients and to what extent. A broker is not normally considered a fiduciary — that is, someone who must work in your best interest,” he said.
Robinhood, as a broker-dealer, is required to adhere to he Securities and Exchange Commission’s Regulation Best Interest rule, which requires these companies to only recommend financial products that are in their clients’ best interest. Indeed, in a disclosure provided on its website, Robinhood maintains that as a broker-dealer the recommendations it provides “will be made in your best interest, without placing the interest of Robinhood ahead of your interest.”
But Robinhood also notes that, while the company doesn’t receive commission of fees for the recommendations, it “still makes money from the trades you place as a result of receiving” the recommended portfolio. This includes payment for order flow, as well as money earned from the interest charged on a margin balance and the interest for uninvested cash deposited with the company’s partner banks.
On Robinhood’s “Help Center,” the company said that one of the main criteria it uses in choosing ETFs for clients is the expense ratio. “Our algorithm favors low expense ratios because this means less of your investment is going towards this fee,” the company noted. Other considerations include the total assets under management by the ETF, the fund’s trading volume, and the fund’s tracking error.
One question on the Help Center addresses the possibility that all four ETF recommendations could come in the form of Vanguard funds. “Vanguard is an investment firm that manages ETFs, and their ETFs tend to score well when it comes to the criteria our algorithm cares about: they’re large, they’re traded frequently, and they have low fees, among other factors,” the company stated. “This doesn’t necessarily mean that our algorithm will always recommend Vanguard ETFs.”
Robinhood also cautioned that the portfolio it recommends could vary from day to day as new data is fed into the algorithm driving the recommendations.
Still, financial advisers offered words of caution for first-time investors thinking of using investment apps like Robinhood:
Platforms like Robinhood can be good learning tools
These new features are being ushered in after a year in which Robinhood found a captive audience of freshly-minted day traders seeking to get rich on meme stocks like AMC AMC, +2.42% and GameStop GME, +0.39% and cryptos like Dogecoin DOGEUSD, -0.51%.
Part of what made services like Robinhood appealing to new investors was the low barrier to entry. Unlike more traditional brokerages, many services came with low or no fees (though customers may have paid the price in other, less explicit ways.)
With volatility comes the excitement of new blood. Many investing apps and services, like Robinhood, have also historically focused on educating their younger, relatively greener users, particularly in times of market volatility.
Some experts applauded Robinhood’s push to educate their new users and steer them toward diversified assets. Dennis Nolte, a financial adviser with Seacoast Investment Services in Winter Park, Fla., called the initiative “outstanding.”
“Knowing who seems to be gravitating to Robinhood — lots of younger investors with ‘smaller’ investment dollars,” he said, “it’s outstanding, especially since many of these investors are focusing on the “gambling” aspect of investment dollars at risk.”
Portfolio diversification can obviously provide safety
Most financial experts compare chasing a big return by buying and selling stocks to gambling in a casino. As a result, it’s a very risky approach, but can lead to large rewards in some cases. Still, diversification provides more safety.
“The risk of owning one stock is known as ‘idiosyncratic risk,’ where you are exposed to the risks of a single stock or company,” George Gagliardi, founder of Coromandel Wealth Management in Massachusetts, previously told MarketWatch.
So how do you offset that risk? “Studies have shown that you need to own at least 10 different stocks in similar amounts in order to reduce most of the idiosyncratic risk, and even better 20 or more,” he said.
“‘Studies have shown that you need to own at least 10 different stocks in similar amounts in order to reduce most of the idiosyncratic risk, and even better 20 or more.’”
— George Gagliardi, founder of Coromandel Wealth Management in Massachusetts
One way to offset the volatility in stocks is to hold the shares for a long time. From day to day, the price will go up and down. But if the company is generally on an upward trajectory, holding those shares for a long time will avoid that volatility.
Of course, companies do go bankrupt, and stockholders can lose out when that happens. Because trading securities is so risky, it’s not an ideal way to invest money toward longer-term goals.
For those goals, it’s better to put your money into something like a 401(k) or an IRA — in most cases, that money will be invested in funds. Funds, including ETFs, still carry their own risk, but it’s different from buying and selling stocks.
Here the concern is more about systemic risk. A single company’s shares falling won’t hurt fund investors too much. But if there are large movements in the stock market DJIA, -0.27% SPX, +0.24%, that can have an effect.
Investment apps can push investors toward risky behavior
Nevertheless, the service doesn’t fully eliminate some of the issues that come with the ease of investing with trading apps. Some have previously compared the ease and access offered by platforms like Robinhood as having “Vegas in your palm.”
Some tech-based platforms have gone a step beyond what Robinhood has done to help investors avoid reckless behavior. Betterment has historically disallowed its customers from trading individual stocks, instead limiting them only to ETFs.
“One of the biggest concerns is newer investors seeing a ‘hot’ stock, but not fully understanding the ramifications of investing in it and producing serious risk,” Dan Egan, vice president of behavior finance and investing at Betterment, said.
Trading isn’t the same as investing
Chances are many, if not most, people signing up for Robinhood are interested in trading stocks. But that isn’t the same as long-term investing or planning, and Robinhood may be limited in its ability to encourage longer-term thinking.
Sure, many people manage to score a few bucks by buying and selling stocks at the right time. For the average retail investor, though, actively trading stocks isn’t the best way to build a nest egg.
And there’s the rub: Novice investors may be better served by using a platform that provides them with ongoing financial advice and education — or turning to a more traditional adviser.
In the meantime, Royal says, “ETFs are a great starting point for novice investors, since they offer diversified exposure to a specific area of the market. But that doesn’t make all ETFs a good investment nor does it make them all the same.”
He advises a long-term strategy: “ETFs invest in a range of assets, from single-sector funds to broadly-diversified funds based on the S&P 500 SPX, +0.24% Index, and your returns depend on what exactly the fund is invested in.”
“This diversification can reduce the risk for new investors of buying a few individual stocks,” he adds.