Don’t Jump In Head First

A couple of months ago I was a little puzzled at a report that the major investment firms were reducing their trading commissions to zero, but, at the time, the report was a little short on the whys, just noting that Schwab was leading the way. But a couple of weeks ago my wonder was cleared up by this report in CNN/Business:

Robinhood’s free-trading ethos turned the online brokerage industry on its head.

Established players were forced to rewrite their business models by abolishing commissions. The extreme disruption even prompted the blockbuster merger of industry leaders Charles Schwab (SCHW) and TD Ameritrade (AMTD).

Robinhood, the zero-commission online broker that recently surpassed 10 million users, is celebrating the rapid change it helped usher in.

“Robinhood pioneered commission-free investing in stocks,” Vlad Tenev, Robinhood’s co-CEO, told CNN Business. “We can be really proud of not just creating a world where our own customers don’t pay commissions, but customers of other brokerages have benefited as well.”

When it comes to investing, it’s important to understand how money is made and lost, and I didn’t understand how Robinhood – and all these other firms – were managing to stay afloat if they were offering one of their services for free. A little digging brought this Money article to light, and it contains that answer.

One way Robinhood can provide commission-free trades is by making money on the interest from the assets it holds within accounts, a practice that’s not unusual for brokerages.

Ah! But there’s more.

The other way it makes money, though, is through a subscription to gain access to margin (or borrowing money to invest more than you can afford with your own money).

For these subscriptions, you’re essentially paying a monthly fee to borrow money to trade stocks. And if those trades go sour, you could lose your money very quickly.

It’s worth expanding that cautionary paragraph into noting that Robinhood, by lending you that money, is assuming risk as well in that if your margin investment fails, they could lose their money as well if you go bankrupt; the subscription fee ameliorates, if not eliminates, that risk.

If you’re considering using Robinhood, or already an active member, the Money article is worth a read, although like any article on investing and investments it should be taken with a carefully considered grain of salt. Money is definitely an old-line publication (more than 45 years of existence), and in this area it should be considered to be weighted towards the conservative end of the opinion spectrum, or protective of old-line institutions, so when it cautions against using Robinhood, keep that in mind. But it’s arguments are worth the evaluation if you’re an investor, particularly if you’re a younger investor who grew up with a smartphone in your hands.

Continuing the theme, if you’re in or considering the Robinhood camp, it’s worth playing devil’s advocate with yourself. While I’m a slug and not likely to use Robinhood rather than my current adviser, I’ve been intermittently playing the role for the last couple of weeks. Here’s what has caught my attention:

• Investment services often come bundled with adviser services, and Robinhood marks a potentially large disruption of this tradition. Traditions often exist for a reason, and this is worth carefully considering. On the pro side of investment advice is that markets are complex feedback animals that can fool even the pros; unless you’re a pro, why do you think you should be using Robinhood to avoid fees? On the other hand, the ethics of some advisers have been sadly lacking, and the industry, as a whole, often resists pressure for licensed professionals to pledge to put their clients first. Of course, the best do for the best of reasons (it’s both honorable and profitable to do so), but others cannot see beyond the tip of their nose and lead their clients down the path to financial hell – there’s not much repeat business down in that hole. And once you make the mistake of investing on a high note and selling on a low note, it’s rare that you’ll get your money back. Robinhood certainly won’t cover your losses. Oddly enough, your only chance of recovering a loss is if you got caught in an investment scam, such as the one put forth by ProNetLink (PNLK) back during the dot com bubble. I put in about $20,000, thought I’d lost it all, and then SEC enforcement actions, IIRC, managed to recover nearly all of that money back. But – ironically – if it’s not a scam, if you just screwed up through inexperience, wave goodbye to your money. You won’t get it back. Period.
• Robinhood doesn’t offer free investment advice. Think of this as unbundling. Traditionally, you’d pay your adviser for the advice and for the actual access to the market; they’d also make money off your uninvested assets, as does Robinhood. The problem called churn can then appear, as a dishonorable adviser recommends numerous buys and sells, saddling you with commissions and short-term gain taxes. Robinhood may reduce or eliminate this problem, as the adviser loses the general motivation to recommend numerous buys and sells; however, it’s not impossible for an adviser to have covert relations with companies they are recommending, and which benefit in some way from having their stock moving in the markets. When officers of the company own large amounts of the stock, they wait for the price to rise to an unwarranted peak, and then sell. This is often called pumping and dumping, and a dishonest investment adviser can easily participate in these schemes. Unbundling is not a panacea.So is this unbundling a good or bad thing? As an investment adviser becomes less dependent on commissions, they also lose that income they were presumably making through investment of your uninvested assets. Therefore, I would expect advice to cost more. Is that bad? Is cheap advice of the same quality as expensive advice? Examples can go both ways, so I just suggest you approach the question carefully. An up-and-comer may have cheap, quality advice as a way to establish a position; if you find such a source, be aware the price will go up once the advisor becomes established. And, while numerical analysis of the results of the advice is a worthy pursuit, that’s not the singular method of evaluation. It’s worth considering the adviser themselves: do they come off as fast talkers, or charismatic? Do some research on their reputations and backgrounds, if they’re independents or working for a bigger organization. This advice worked just as well 50 years ago as now; I reiterate it because the pervasive Silicon Valley belief that computers solve everything just ain’t so.
• In the CNN/Business article, Robinhood co-CEO Vlad Tenev is quoted as saying:
  

  “It just didn’t make sense,” Tenev said of the trading commissions charged to buy and sell stocks. “These were purely electronic transactions.”

  Either Tenev is deceitful or not thinking very well. There’s a tremendous amount of infrastructure and intellectual effort that went into putting together an Internet and the ability to run stock markets in an electronic format, rather than the old-style traders shouting out bids on a stock market floor. I’m a cautious fan of the consumer paying directly for what they are consuming, and, while I understand that makes me a bit of an oddball in this age of commercials paying for everything, starting way back in the Age of Radio^[1], I really do wonder how that secondary approach to paying for that access  – because the elevated prices of products paying for those commercials means you pay, nonetheless, for that access – tends to mutate the transaction in insalubrious ways. That said, I don’t know how this plays out – pro-rating all these buys against the fixed costs will reduce the cost per action to pennies. This doesn’t seem to be a Tragedy of the Commons situation, since the resource will be practically inexhaustible; however, as Money points out, psychologically this is a situation in which the inexperienced trader will be encouraged to indulge in a lot of activity, and that, in investment terms, tends to lead to disaster. Keeping a brake on activity in the form of fees seems like a good idea, no matter how insulted the investor might be at the idea that they should be reined in.

• Fractional shares:
  

  … Robinhood announced a series of new features on Thursday, including the launch of fractional share trading. That feature will allow investors to invest in stocks and ETFs with as little as $1 — regardless of the price tag.

  Some young investors may balk at cost of even buying a single share of Amazon (AMZN), Berkshire Hathaway (BRKA) and Google owner Alphabet (GOOGL) — each of which are priced at north of $1,000. Even Apple (AAPL) stock is priced at nearly $300.

  I note that CNN/Business glosses an important point – the benefits of ownership. This is not merely the right to share in dividends and capital gains when you sell, but to also vote at annual meetings. A share represents some fraction of ownership. For some investors, this is the most important aspect of owning a public company. Here’s what Robinhood states when it comes to fractional shares and ownership:

  We will aggregate and report votes on fractional shares.

  I don’t even know what this means! My most charitable reading of this is that it means a fractional share owner can vote their fraction, which will then be aggregated with all other fractional share owners held beneficially by Robinhood. So, I hope, the impact of your ownership is not negated by owning a minor piece of a share. CNN/Business‘ loss of focus on the truly important is troubling.

• On the same topic, though, is circumvention. Step back and review the ultimate goal of an investment evaluation of a company^[3]: in relation to its future prospects, is its market capitalization overvalued, equable, or undervalued? Remember, share price does not embody company value, but rather it’s merely the result of the equation
  

  Share price = Market cap / Share count

  A company can modify its share price simply through the use of a share split, which reduces the price of a stock share while increasing the number of shares held by all shareholders, thus not materially impacting shareholders, or, more rarely, through a reverse split, which reduces the number of shares held by each shareholder and increases the price per share. In neither case is the market cap modified.

  My point? Because companies can utilize these actions to control the ultimate price per share using an action generally both legal and ethical^[2], then it’s worth asking why they do or don’t. In the case of the relatively rare reverse split, it’s because certain markets do not like to carry what are called penny stocks; they require a share of stock to have a price greater than some arbitrary value, such as $1.50. A company desires to stay listed for two reasons: because it lends credibility to it in the eyes of its customers, and because, if they have a treasury of their own shares, it stabilizes the value of that treasury, which might otherwise become quite volatile in penny stock land. So companies that are struggling will use a reverse split to pump up the price per share, even though it has no direct impact on their vital market cap number – although, indirectly, if they are delisted from a market, their market cap could plunge.

  But why not lower a high price per share? Not only does a high price per share discourage small investors, it also discourages those who use call and put options as part of their investment strategy, as these contracts operate in terms of 100 shares, which makes the requirements of a stock with a high price per share out of the reach of all but the very well off investor. Selling a put on Berkshire Hathaway’s BRK-A stock, currently priced at nearly $338920/share, would put me on the hook for roughly $33,800,000, depending on the strike price, if the put were executed.

  Warren Buffet, CEO and Chairman of the aforementioned Berkshire Hathaway, does have a statement on the matter:

  “I don’t want anybody buying Berkshire thinking that they can make a lot of money fast. They’re not going to do it, in the first place. And some of them will blame themselves, and some of them will blame me. They’ll all be disappointed. I don’t want disappointed people.

  The idea of giving people crazy expectations has terrified me from the moment I first started selling stocks.”

  In other words, the reasons for keeping a price per share high may be varied and even personal.

  Which brings me back to circumvention. Robinhood may be laying bare the mechanisms for circumvention of corporate intentions, and I don’t know if this comes out of the wash as a bright white or a big blot on your shirt. I suppose it’ll depend on your view of corporations: are they all evil with malicious intentions, or can they have ethical intentions which actually work to the advantage of investors, even when those investors therefore cannot invest in the company? Your call.

• Finally, Robinhood’s stated ideals of making investing more available reminds me of some observations made just prior the Great Depression (the one back in the 1930s; the Great Recession of 2008-2009 is a different and not as enormous dip in the world economy), and that was that a number of investors had made (and, for some, subsequently lost) fortunes in the market, and now every taxi driver and janitor was investing in hopes of making it big, just like these new millionaires (back then, that term really meant something). You can bet that when the Great Depression hit, all of those little investors lost it all and ended up in the soup lines. Now we see Robinhood, perhaps with the best of intentions, attempting to engender the same toxic enthusiasm for investing.Sure, it’s merely a similarity I’m noting. Could be nothing more. But it’s worth investigating this further if you think Robinhood is great stuff, and to think about the consequences for you if the market folds like an origami unicorn under a boot heel.

So there you are, some thoughts on Robinhood. I’ll tell you what, I’m just glad to get them out of my head.

¹ Note that I write from an American context; my understanding is that in other countries, you often had to buy a license to use your TV to access broadcasts. I have no personal experience with this model, and whether it meant there were no commercials, how much cheating occurred, etc. In yesterday’s Age of Cable, you paid for that access AND you still had commercials. I’m old enough to remember the first cable companies advertising that buying cable meant No More Commercials! So much for that corporate promise.

² If you came to a stop at the word ethical and snarled, you need to go back and review your knowledge of how share prices relate to market capitalization, and what this all means. Regrettably, many people don’t stray out of the realm of share prices, which is a hobble on achieving their investment goals.

³ Most investors invest to make money, but some people use the public markets for influencing companies, so my statement isn’t entirely accurate.