Welcome to the third installment of Inefficient Markets, where each week we take a brief deep dive into one of the many markets in today’s world and learn what’s really beneath the covers. Today’s focus centers on the stock market, and more specifically the influence of low-cost trading apps like Robinhood, which have transformed the online brokerage market in recent years. As always, any feedback or criticism is greatly appreciated. To put my money where my mouth is, I pledge to donate $10 to the first 10 meaningful comments below -- simply include the name of your preferred charity of choice with your comment.
Unless you’ve been living in an actual cave (not your man cave) for the last 4 months, you’ve probably heard of Robinhood. You may have heard one of Scott Galloway’s rants about why it is corrupting today’s youth, particularly young men. Or more likely you at least heard about the tragic suicide of Alex Kearns just a few weeks ago. But if you’re also like 99% of Americans who gloss over headlines without going too deep, you probably are not expert on the stock market and don’t really know if apps like Robinhood are a good thing or a bad thing. As we’ll explore below, there’s certainly pros and cons and like most things, the nuance matters. After reading this essay, I But I hope you’ll at least have a better understanding of the tradeoffs, and whether you are a parent, an investor, a politician, or a Robinhood employee, you will be better equipped to advocate for a path forward.
What is so special about Robinhood anyway?
This probably goes without saying for most readers, but just in case my mom is reading, Robinhood is the most popular online brokerage app today. It was founded in 2013 by two Stanford classmates who previously worked together for a high-frequency trading firm. It’s kinda like a new version of E-TRADE, which twenty years ago taught Americans that stock trading was now so easy even a baby could do it.
Back then, E-TRADE was busy disrupting the previous financial market system that required investors to pick up the phone and place an actual call to their “broker,” who was some guy in a suit who lived in New York City, a la Leonardo DiCaprio in Wolf of Wall Street. E-TRADE allowed investors to buy or sell any stock for just $10 per trade, which “democratized the system,” making stocks accessible to millions of more Americans. But E-TRADE is an old company, and so never really figured out how iOS and Android and the modern internet works. So while E-TRADE still exists (recently acquired by Morgan Stanley) and isn’t going away, Robinhood is booming in popularity, particularly among young people with smartphones. Except there’s a catch. Robinhood didn’t just reduce the cost of trading, they made it free. Free like Facebook. Free like Instagram. And what do we know about products that are free for users? A free product means you are the product.
Robinhood also followed the playbook set by every other successful Silicon Valley startup. Reduce friction. Gamify the experience. Increase engagement. Focus on the users that love your product, and push people down the funnel until they’re so addicted to your product they’ll never stop. And with a critical mass of addicted users, there are plenty of ways to make money.
So how does Robinhood make money?
I spent at least a few hours this week dreading about how to explain how Robinhood makes money. I studied finance. I’ve been investing for 10+ years. And I still barely understood. So to explain it to someone like my mom, well, it’s complicated. I did make a fairly simple spreadsheet modeling a hypothetical market maker’s order flow to show how Robinhood’s total fees are actually higher than previous online brokerages. But that was still confusing. Then Nathaniel Popper at the New York Times was kind enough to write a brilliant article yesterday, which neatly explains how Robinhood has Lured Young Traders onto its platform. In that piece, Nathaniel explains things in very simple terms.
At the core of Robinhood’s business is an incentive to encourage more trading. It does not charge fees for trading, but it is still paid more if its customers trade more.
I highly encourage reading the whole piece, as it is super informative and well worth an extra five minutes of your time. Or if you only have one minute, the best analogy I came up with was to reference another 90s classic: Office Space. It’s like taking a fraction of a penny from every user, every day, on every trade. So the more trades users make, the more money Robinhood makes.
Why does this matter now?
Robinhood had been growing in popularity fairly steadily throughout the past 5 years. As an early 30s male living in San Francisco, I know that at least half of my peers have had Robinhood accounts for awhile. But just like Zoom, Robinhood has been a hands-down beneficiary of the pandemic. Since the start of the pandemic, Robinhood added 3 million new accounts. According to its CEO, about half of those new users are first-time investors. And with everyone stuck at home, no sports to bet on, and online poker still mostly illegal, the stock market quickly became America’s new favorite way to gamble. Robinhood saw trading volumes skyrocket by three-fold over the year prior, and user deposits increased by 17-fold, according to a CNBC interview from April. On its surface, none of this is bad. More Americans having access to the stock market is a good thing. Americans learning how to build wealth through investing is a great thing.
The challenge is that Robinhood’s goals are not to teach Americans how to invest responsibly. Just like Anheuser Busch’s objective is not to teach Americans how to drink responsibly. The goal is to get people to drink more. And make money. Robinhood makes money the more people trade. And so their incentives are fundamentally misaligned with their users’ objectives. So long as this remains the case, Robinhood will continue to find ways to acquire more users and get them to trade more.
In American culture, we believe deeply in individual responsibility. It’s not Smith & Wesson’s fault if a gun they manufactured is responsible for a mass shooting. It’s not Mark Zuckerberg’s fault that Trump lies to users on Facebook. And so it’s certainly not Robinhood’s fault that a 20-year-old committed suicide because he misinterpreted how to use its app, and wrongfully believed he’d lost $700,000. I actually believe this is a good thing. Since I started this essay last week, I’ve checked my Robinhood account probably a hundred times. I probably have a mild to moderate grade addiction right now. But that’s my own fault. I still have the choice to stop. I also have the choice and freedom to learn more about how Robinhood makes money. I can (and have) learned more about options trading strategies in the last month than I did studying finance 10 years ago at Dartmouth.
Because of what I’ve learned, I think Robinhood is dangerous. It’s dangerous in a similar way to Facebook. It’s dangerous if its power goes unchecked. I do not think the company is evil, but I do think they are misguided. For most Americans, the right investing strategy is to take whatever discretionary savings they have, and put it into a few diversified index funds, and only look at it once per year. Just like you shouldn’t go to Vegas with money you expect to come home with, most people should not be day-trading on Robinhood.
The future of Robinhood: What happens next?
Because I’m naturally an optimist, I think Robinhood will figure things out eventually. They have a very talented team, and it is true that a massive user base can be monetized in multitudes of ways. But they need to start developing those alternative revenue streams sooner rather than later. As it is today, Robinhood is like the earliest versions of Tinder or Grindr. Great for the short-term. Give users a healthy stream of dopamine hits (or hookups), and they’ll keep coming back. But eventually, they’ll want something more. Robinhood has the potential to educate millions of young Americans about responsible investing. In 2020, that’s a hard thing to do. Ben Graham published The Intelligent Investor in 1949. It’s still incredibly relevant but is 640 pages long. We all know that most 20-year olds with $600 week of unemployment benefits are unlikely to sit down and read for 40 hours, when they have the instant gratification of Tik Tok, Bumble, and Robinhood at their fingertips.
If I were in leadership at Robinhood, I’d try to mimic Hinge’s approach to winning in the dating industry. Their tagline is simple: The dating app designed to be deleted. It would require a massive shift to its current business model. Doing so won’t be easy. But if done successfully, parents will want their children to start using Robinhood at a young age. Middle school math teachers will ask their students to pull out their Robinhood apps in class and integrate it into lessons. Young professionals will auto-deposit 5% of their paychecks into Robinhood because they trust it to look out for them and ensure they build wealth for the long term. None of this happens today. But the future is not set in stone.
Thanks for reading. I look forward to your comments and ideas below.