The recent astronomical rise of meme stocks brought many people to the stock market for the first time, typically through Robinhood, the commission-free stock trading app that has promised to democratize access to the stock market. According to a number of financial advisers, the app appears to be democratizing certain types of risky investing, like day trading. There are potentially less risky — and equally user-friendly — app options out there.
The thing is, it’s impossible to predict the market. Many professionals spend their entire careers trying to do so, with varying levels of success. And regular people who invest in individual stocks in the short term are likely to lose money, no matter what you hear on TikTok. Study after study has said so.
Particularly worrisome are “herding events,” including those fomented in Reddit’s WallStreetBets community that encouraged hoards of people to invest in certain stocks, like GameStop and AMC. On Robinhood, people were already more likely than other retail investors — people who aren’t professionals — to invest in the same stocks as other users, according to Christopher Schwarz, faculty director of the University of California Irvine’s Center for Investment and Wealth Management and one of the authors of a paper looking at outcomes of investor behavior on Robinhood. When too many people crowd a stock, “the price of the stock overshoots what it should be and over subsequent days it corrects.”
The study, which was conducted using Robinhood trading data from 2018 to 2020, found that those who invested in the top 10 newly purchased stocks saw returns in the next month that were 5 percent lower than that of the S&P 500 index — a “pretty horrific” outcome, Schwarz said. Robinhood is the only trading app that’s disclosed user holdings so the researchers did not compare investors’ performance on its competitors.
Put another way, “if you were a Robinhood user and bought those top 10 stocks every day, you would have lost 97 percent of your money over two years,” Schwarz said. He added, “It’s probably one of the biggest negative returns documented by academics.”
Robinhood has been criticized for letting people trade on credit and for making investing feel like a game, using elements like confetti and color-coding in the app to stimulate trading.
“We are proud to expand access to the financial system and enable millions of people to learn and invest responsibly,” a Robinhood spokesperson told Recode. “We see evidence that most Robinhood customers use a buy and hold strategy, and research published by the National Bureau of Economic Research found that Robinhood customers acted as a market stabilizing force through market volatility in 2020.”
Still, even professionals don’t have a great track record picking stocks.
Investors in equity mutual funds consistently underperform the S&P 500 index, according to Cory Clark, chief marketing officer at financial services market research firm Dalbar and primary author of a longstanding report on the topic.
These institutional investors fall prey to confirmation bias, in which a positive trade makes them overly confident in their abilities, he said. There’s reason to believe regular people could be even more susceptible.
“In the context of day trading, it’s that on steroids,” Clark said. “It’s very dangerous for average investors.”
All this is to say, day trading — buying and selling stocks over short periods of time — is not a reliable way to build wealth, according to these financial advisers.
As Gretchen Behnke, principal at Pearl Financial Planning, put it, “Individual stock picking is almost always going to be too risky for regular people.”
What she and every other financial professional we spoke to suggested was the opposite of day trading individual stocks: investing in highly diversified and low-cost exchange-traded funds (ETFs) or index funds and leaving that money in there for a long time.
Of course, speak with your own financial adviser or investment professional to decide what’s best for you.
“Prudent investment can be pretty dull,” Zach Teutsch, a managing partner at the advisory firm Values Added Financial, told Recode. “If it’s fun, it’s probably because someone gamified it to make it more enjoyable as entertainment — all to help profit off of the investor.”
How to best use Robinhood and other day-trading apps
The safest bet on Robinhood would be buying a wide variety of ETFs, rather than individual stocks like GameStop or even riskier products like options. Like mutual funds — which you can’t purchase on Robinhood, but you can buy on competitors’ apps like Schwab, Fidelity, and Vanguard — ETFs are low-fee baskets of professionally managed stocks that follow a particular investment strategy. Some ETFs and mutual funds, for example, provide exposure to all the stocks in the S&P 500, while others are dedicated to different company sizes or industries.
One such fund, Adasina Social Justice All Cap Global ETF, includes 900 companies that Adasina says are in alignment with social justice movements like Black Lives Matter.
“This whole situation with GameStop came from popular discontent with wealth inequality,” Rachel Robasciotti, the founder and CEO of Adasina Social Capital, said. “If you’re ready to put your money where your values are, do it in a smart way. Use a fund that’s diversified.”
Financial advisers encourage investing in such funds to give people exposure to a wider range of stocks than they would get by picking individual stocks, so that their risk is more balanced. The idea is that hopefully declines in certain stocks are countered by gains in others.
Many financial advisers also suggest leaving your money in these funds for long periods of time. Teutsch likens trying to get huge returns quickly to substituting a recipe that requires 400 degrees for an hour with double the temperature for half the time.
“That’s what people try to do in investing. That’s not how investment works,” he said.
When people are investing in the short term in individual stocks, it can be tempting to buy and sell with market swings, he said. Huge gains — like the more than 1,700 percent rise on GameStop this year before its subsequent fall — are possible, but so are huge losses. Stocks are volatile in the short term, but in the long term, the market as a whole tends to go up, which is why advisers suggest investing money and then leaving it alone for years if not decades.
Longer-term investments are also better from a taxation point of view. People who are new to day trading on Robinhood might be surprised by how much investment income is taxed. If you sell your investments within a year of buying them, for example, you could be taxed at significantly higher capital gains rates than if you were to hold onto them for more than a year.
Financial advisers we spoke to say, if you’re going to day trade on apps like Robinhood, make sure you’re doing so with only a small percentage of your money.
“You can take a small amount of money and play with it, but consider it an entertainment expense,” Behnke said. “This is separate from savings and retirement.”
Similarly, the experts also say not to invest money you don’t have. Robinhood lets people trade on margin, meaning that they give you a small loan. That potentially allows people to invest — or lose — more money than they have.
Other investment apps take a different approach
The latest buzz around meme stocks has meant a greater consciousness of investing in general, as a way to compound wealth and save for retirement. And Robinhood’s rise has been paralleled by increased popularity in investment apps that don’t involve day trading, like Acorns, Betterment, Wealthfront, and, to some extent, Stash. Acorns, for example, saw 100,000 new customers the day of the GameStop news.
For a fee, these apps handle the slow, boring work of investing your money in diversified funds (usually ETFs) as well as provide some other services like portfolio rebalancing and tax-loss harvesting so that your money can make more money — slowly but steadily. We’ve outlined how they work:
Acorns ($1-$5 a month)
Acorns lets you automatically add money to a wide variety of ETFs in a range of pre-selected portfolios, through regularly scheduled deposits and by rounding up money on your purchases and putting that money into your account. It also does unsexy stuff such as reinvesting dividends and rebalancing your portfolio.
Acorns CEO Noah Kerner wants customers to invest their money as long as possible.
“People get themselves in trouble because suddenly people get panicked and lock in a loss,” he said. “That’s the moment to stick with it and even invest more.”
Acorns has a monthly subscription model, as opposed to Robinhood, which doesn’t charge users but makes money depending on the volume of trades. Kerner believes Acorns’ business model allows it to better serve its customers.
“The business model dictates how a company makes decisions,” Kerner said. “I’m not in the business of trying to make decisions misaligned with your best interests.”
Betterment (0.25 percent of assets under management per year)
Betterment sets investors up with a range of diversified ETFs based on a number of factors, like their age and aversion to risk, all of which are determined by a questionnaire.
“This is not short-term, speculative, to-the-moon kind of stuff,” Dan Egan, VP of behavioral finance and investing at Betterment, told Recode.
Investors can let Betterment choose for them or decide to put their money into socially responsible portfolios, like those related to preventing climate change or encouraging social justice.
Accounts have something called tax-loss harvesting, which helps people lower their tax bills by using losses to offset gains. The app also notifies people trying to sell off assets how much more they might have to pay in taxes compared with keeping the investment in longer.
Like Robinhood, Betterment uses visual cues within the app. Unlike Robinhood, whose color-coding is based on how much a stock is up or down and may cause people to react to prices after the fact, Egan says Betterment uses color-coding to motivate people to follow their stated investment goals.
“You can’t change yesterday’s returns but can make changes to put your financial plan on track,” he said.
Wealthfront (0.25 percent of assets under management per year)
Wealthfront also uses a questionnaire to determine the best investment strategy for people, depending on criteria like age and risk aversion. The site is designed to operate very differently than Robinhood.
“We are definitely on the other side of the spectrum from a day-trading platform. Our whole thesis on investing is you can’t control or beat the market on a consistent basis,” Kate Wauck, VP of communications, said. Instead, the company puts people’s money in low-cost diversified index funds.
It also does portfolio rebalancing and tax-loss harvesting, things it assumes most regular investors don’t want to be involved in.
“We’re for people who’ve got some money saved in their bank account, and know it’s not making money, but don’t want to spend time thinking about investing and being actively involved,” she said.
Stash ($1-$9 per month)
Stash is sort of an amalgam of Robinhood and Acorns. Like Robinhood, it lets you invest in individual stocks and ETFs but tries to get you to hold on to those for a longer term.
“We purposely built a bad day-trading system,” its founder and CEO Brandon Krieg told CNBC earlier this month. “Our brand and our message, as well as our onboarding, are not attractive to someone who’s coming to day trade.”
Like Acorns, it encourages people to increase their investments with automated deposits and by rounding up money spent on purchases. The user is responsible for picking individual stocks and ETFs to build a portfolio, but the app prompts the user to diversify those assets.
Open Sourced is made possible by Omidyar Network. All Open Sourced content is editorially independent and produced by our journalists.
Get more stuff like this
Subscribe to our mailing list and get interesting stuff and updates to your email inbox.
Thank you for subscribing.
Something went wrong.