Robinhood has introduced a lot of people to investing in the stock market. That’s a good thing, but some of the brokerage’s actions may lead people down a dangerous path.

The company has gamified trading and rewards a short-term mindset. It also encourages trading with margin and using options which can be very bad ideas, especially for less-experienced investors.

Robinhood does offer commission-free trades, but that’s table stakes these days for brokerages in the United States these days. Simon Erickson joined Dan Kline on the May 26 “7investing Now” to look at the plusses and many minuses of the controversial brokerage.

A full transcript follows the video.

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Dan Kline: And that’s part of that is something that Robinhood has sort of kind of done. They’ve taken this attitude of, Hey, everyone can invest. And they, in theory have made their platform really easy to join. I say, in theory, because I went through the process and could not connect it to my bank account, I have never had that problem on the other services I use. So they have no customer service. So when things don’t work, it’s a problem. But they started with what I would consider a noble mission. But Simon, that’s not actually what they’re doing, right?

Simon Erickson: It’s interesting. There’s two sides to the coin here, Dan, it’s been a very controversial company. When we talk about Robinhood, I think that the headline or the first thing that comes to mind when you talk about Robinhood is Oh, hey, there’s no commissions, I get to trade. I can even do fractional share trading with a lot of securities and don’t have to pay any commission.

So what does that do? It makes you kind of in your mind think, well, I can get in and out as often as I want to, with these stocks, trade as many times as I want to, and even in a certain week or a certain day, and not have to rack up those commissions that we’ve gotten used to. The problem is we don’t really encourage that. And that’s really very different than long-term investing. And we’ve even seen some issues with GameStop, or other short term traded securities come up or the platform actually shuts down and says, Hey, we’re not going to allow any more buying on this, because it’s not an integrated Clearinghouse like so many of the other brokerages and exchanges have. So there’s some complexity with Robinhood, I think that people should really be aware of.

So let’s look at some of the fundamental dangers here. Because there’s everybody offers commission-free training right now you can get that through your bank account. In many cases, it is not difficult to get free trades. Fractional shares aren’t everywhere. I use TD Ameritrade as my main platform. They don’t offer it yet, though, I believe they will at some point. So there are some positives to Robinhood.

But here’s the negative when you make a trade on. And I’m not saying buy a stock, because it really is trading when you make a trade on Robinhood, you get gamified celebration. And really, you should be getting celebrations for hey, you’ve held this stock for three years that you should be getting education on why making a lot of trades might seem like a good strategy, but it generally doesn’t work. 97% of day traders lose money, Simon, they’re also doing a couple of other really dangerous things. Maybe you want to elaborate there.

Yeah, absolutely. I echo everything you just said Dan. In fact, we have a monthly subscriber call and a new member welcome call as well every month that we host on zoom. And you always do such a good job of explaining the benefits and the power of long term investing, as opposed to trying to get in and out frantically and figure out what your your price is going to be. The other danger of Robinhood is a practice known as payment for order flow.

And what this means is that the exchanges themselves are not fulfilling the orders, there are financial middlemen that are actually fulfilling the orders in the transactions themselves. And what that means is often times investors are not actually getting what the pricing that is advertised on the exchanges are it’s not what’s actually being fulfilled in the transactions, there is a more narrow Delta in the bid ask spread that’s being pocketed. And so what that means is that a lot of times investors are not getting the best pricing when you trade through an exchange that has this practice of payment for order flow.

And a lot of the brokerages do it then, you know, Schwab does, Fidelity does, Interactive Brokers does not. But for the large part, Robinhood is getting paid a much much higher rate. When it comes to payment for order flow of what it’s actually having those financial high frequency trading middlemen fulfill the orders are getting a much better rate than a lot of the other brokerages. And this is a practice that was basically banned in the UK in the EU, they thought that it was not for the good of the public or for individual investors.

And they said, Hey, we’re gonna shut this down. And they found that it actually improved the pricing that was achieved for individual investors over a long period of time. It’s still a practice that’s legal here in the United States, Robinhood is not breaking any regulations by doing this. But there’s a lot more magnifying glasses kind of keeping an eye on this. Because this is something that’s questionable whether it’s actually good or not for traders.

Dan Kline: This isn’t even the most dangerous thing they’re doing. I’m gonna throw two out. They are encouraging option trading. That’s one, Simon  I want you to explain why that’s risky. I know that a lot of our friends in the investing space use options lightly. But almost every long term investor I know says don’t use options until you’ve invested for at least a year until you really understand what you’re getting. That’s one. The second danger is they’re making margin trading. That is borrowing money to buy stocks really, really easy. That is horrendous. Simon, why don’t you start with the dangers of options? Again, options aren’t inherently bad, but they’re very, very risky. Simon?

Simon Erickson: That’s right, Dan. There are a lot of other ways that larger brokerages are making money, right? So if you’re working with fidelity, fidelity has got accounts and funds that they’re managing and they’re taking assets under management. They’ve got consultants that are kind of talking people through the stock market, they’re making money in other ways other than just commissions. Robinhood is making money in two ways. One is from payment for order flow. Which is described.

One is from margin interest balances, which is what you just described. So when people are are investing with money that they do not have cash in their account to actually buy stocks, Robinhood is charging them a balance for the money that they’re loaning them the margin that they are loaning to them. This is very, very bad for investors, if the stock prices you’re buying go down, it’s very, very bad if you get a margin call where you have to put the money up front, even if it’s not in the account right there.

And this is something that even though it seems like it’s a great way to juice your returns, hey, I can take some extra risk because I can use money I don’t have, keep in mind, there’s always another side of the coin. And we never know what the market is going to do in the short term, you’re exposing yourself to a lot of short term risk that I don’t think investors should be comfortable taking, if you take margin balances out, especially for options or short term trading.

Dan Kline: And it’s really important to remember that stock prices aren’t predictable in the short term. So if you look at our 7Investing recommendations table of all the stocks I’ve picked, I only have one stock that’s down. And I would argue that it’s the most solid stock I’ve picked in terms of the results, they’ve had the growth potential, sort of all the picture. So in the long term, do I believe that company will grow significantly?

Yeah, it’s tripled in the past three years. In the past six months? Is it down? Yes. So if I borrowed an option, and that was down, they could go and say, okay, you need to put the money in your account to cover this, or you need to sell in a lot of cases you that have to sell at a big loss a stock you believe in.

Option trading is dangerous, because options. When you buy a share of a stock, if I buy tugboat Inc, a company that makes tugboats, I’m just making something up. Remember what the pick and what I’m not allowed to talk about. You buy a share of tugboat Inc for $50. And they say we’re going to turn tugboats into the newest form of entertainment by putting polka bands on them. And this is a terrible idea it tanked but I thought it was going to be great, and I bought 100 shares at $50 each, the worst I can lose is $50 per share.

If I bought an option that that was going to go up and it doesn’t, there’s an endless amount of loss potential as the stock fall. So I don’t even really understand options Simon, you might want to jump in and explain this better than me. But if the stock keeps going up, and I bet it’s going to go down, you could just lose an endless amount of money because you have to buy a share of that stock to cover your bet, correct?

Simon Erickson: Yes, and there’s different types of options, right? There are some that are that are more simplistic and a little bit quote-unquote, safer. If you’re selling your covered call for security you already have because you just want to establish an exit price. That’s something that’s a safer option. If you are buying a naked put that is extremely risky option for options. And there are all points in between these. I think that the point is that even for large-cap securities, even for companies that are traded in large volumes on a daily basis, it’s it’s very unpredictable. And even companies like Apple (NASDAQ: $AAPL), Dan, we don’t know where they’re going to head in the short term.

And I’ve heard stories I’ve personally heard stories from people that thought they were making no brainer option trades on Apple, one of the largest companies in the S&P, and it turned against them in the short term because of an announcement that nobody had any insight into and person lost a fortune, you know, you cannot see something like that in the short term, we highly discourage it. And this is why we have established 7Investing scorecard to be buy and hold. Right We have certainly taken some some of the higher beta higher risk companies that we’ve recommended have taken it on the chin this last month as the market sold off.

But over the long term, we’ve seen the academic studies, we’re very convinced that even with short term sell-offs, the primary correlation between stock market returns in the long term and companies is revenue growth and valuation multiples would jump around in the short term but solid fundamental solid revenue growth over long periods of time five years plus is the key to compounding wealth, don’t step on landmines and expose yourself to unnecessary risk in the short term.

Dan Kline: Guessing at short-term pricing is like betting on the second-quarter score of a basketball game. I’m a big Boston Celtics fan and obviously with injuries we are not going to beat the Brooklyn Nets.

Simon Erickson: Better than my Rockets though, Dan! You made it to the playoffs.

The Rockets didn’t lose every game this year. So if you’re betting, you know, hey, the rockets are playing the Lakers, the Lakers are much better, doesn’t mean the Lakers in the second quarter are gonna have a big lead. And that’s kind of what you’re doing at the end of the game, most times tends to go the way you think it’s gonna go the way the betting line expects it to go. In the middle of the game, it’s impossible to tell and that’s what guessing stock prices are. So let’s recap here before we move on.

There’s nothing inherently evil about Robinhood if you choose to use Robinhood, because it’s an easy-to-use platform and you’re tuning out the noise isn’t what we would pick. There are more customer-friendly companies. I use TD Ameritrade we use Stockpile as a company to buy fractional shares. We’re not recommending any of those specifically, but I would go towards credible companies that have a back end of customer service that have an actual person now, is Bank of America going to make it easy for you to get a person? No, it isn’t. But there are people there. Simon, any last thoughts on Robinhood and brokerages before we move to what we’re watching?

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