It’s no secret that the Robinhood mobile app makes it easy for beginners to start investing. However, it’s unlikely that everyone understands the potential risks of using Robinhood to purchase investments. During periods where we have volatile markets, traders with little experience can easily make the wrong decisions. That being the case, how are we as financial advisors going to protect our clients from making bad financial choices, while using popular apps like Robinhood? Here’s how to talk to your clients about the downsides of trading on apps for beginners.
What is Robinhood?
If you’ve never reviewed Robinhood’s mobile app or website, let’s explain why it has become popular in the past several years. Back in 2013, Robinhood was founded to give everyone the ability to make stock and ETF trades for free. Currently the app has a basic trading platform, no minimum deposits, and no trading fees. In addition to purchasing stocks and ETFs, you can also buy options and trade cryptocurrencies.
Why Are People So Interested in Investing Apps Like Robinhood?
For the reasons listed above, Robinhood excellently attracts new investors. Uninvested cash earns interest, investments are incredibly easy to purchase, and few people will have questions about completing a buy or sell order. Yet, like with any website or mobile app that makes trading easy, it’s also very easy to make common investment mistakes. Most notably, beginners will start on Robinhood, but because of the lack of IRA and other tax saving accounts, they’ll likely pay more of their returns over to the IRS in the long run.
What Are the Potential Failures of the Robinhood App?
As a result of not offering 401(k) or IRA accounts, it’s important that you explain these options to your clients before they start investing on Robinhood. There are two major things that beginner investors have trouble understanding which we should clear up.
It’s not a strategy for the long-term.
Source: Seeking Alpha
- Compounding interest builds wealth, but the vehicle you use to grow your capital is what allows you to keep more of it.
Here’s what your clients should know about this. Simply investing your income is not enough if you don’t have a tax advantage. Otherwise, they will be in for a surprise when it’s time to capitalize on your stock market gains.
Have your clients make contributions to their 401(k) if their employer matches. If your client has $100 to invest a month, why not benefit from both the tax deferment and the employer match? It would literally be insanity to keep money on the table. Robinhood is not going to lower your annual tax liability and it’s unlikely that amateur investors understand this.
- Just because tax-advantaged investment accounts are considered “retirement accounts” does not mean there aren’t times when you can make withdrawals without penalties.
How often have you heard, “I would make contributions to a retirement account, but I don’t want my money tied up.” Everyone has short-term goals, but with investment accounts like Roth IRAs, your clients will still have access to money when they need it.
There are several qualified and non-qualified distributions where exceptions apply that will give your clients peace-of-mind about investing for the long-term. Here are just a few of the most important distributions to explain:
- If your client made their first Roth IRA contribution 5 years ago, then they can withdraw without penalties. This is regardless of age and applies if an inherited Roth IRA had its first contribution over 5 years ago as well.
- If your client has a permanent disability, incurs medical expenses over 10% of their adjusted gross income, has to pay for childbirth expenses, or needs to make medical insurance payments while unemployed, they can withdraw from a Roth IRA. Essentially, their Roth IRA will somewhat act like an emergency fund. Knowing this fact alone might convince your clients to consider maxing out their Roth IRA contributions.
- If your client wants to purchase or build a home, they can also take a distribution from their Roth IRA. Younger families especially want to buy a home and might turn to taxable accounts in the event they want to access their money soon. Although there’s a lifetime distribution limit for using Roth IRA funds for this purpose, it’s still something your clients should be aware of.
So far, the opportunity costs of using Robinhood over tax-advantage investing accounts are known to be too high. However, those are not the only potential downsides of beginner investing accounts. Here are some other points you’ll want to explain to your clients.
When Luck Runs Out – Analyzing Risk
Sometimes ease of use leads to lack of investment planning. Based on analysis by Barclays, when retail investors on Robinhood move into a stock, this results in lower returns more often than higher returns. With inexperience, there are often traps that investors fall for, especially in this volatile market. And yet, after an initial short-term win, beginners can easily be duped into thinking that flipping investments is easy. But this confidence could lead to losses when luck runs out.
In addition, these broker apps do not have the ability to analyze risk, like we can at StratiFi. If they are in single- or low-asset portfolios, they might be taking on massive risk when compared to the market. It is more efficient to analyze your portfolio overall, and make sure you are taking risk into consideration.
Most Won’t Beat the Market
Another point that your clients need to know is that it’s much better to have a long-term strategy. Timing the market likely won’t beat a buy-and-hold strategy, and short-term fluctuations are difficult to predict. Picking a few stocks for the short-term also doesn’t mitigate risk. Therefore, fee-free apps can be tricky for beginners. They can simply buy and sell, without thinking about a long-term strategy, and miss returns as a result. And this fact can quickly turn investing into gambling for beginners. Just remember to tell them that the house always wins, and in this case, they might be playing against major hedge funds and institutional money.
Robinhood – good for having fun, bad as a long-term strategy, risky for beginners.
CNBC’s Jim Cramer recently said he believed that Wall Street investors were tricking beginner investors on apps like Robinhood. During premarket trading there has been an unusual amount of bankruptcy stock buying activity. Due to the fear of missing out, investors purchased once the markets opened and these stocks were sent soaring. This caused short squeezes, followed by price plunges. And although not all of this was caused by Robinhood buyers specifically, it’s these potential traps that an amateur investor can easily be caught up in. So, instead of letting your client get fooled by randomness, it’s better to educate them on long-term strategies that actually lead to financial success.