An app that let’s you quickly and easily trade stocks with no transaction fees? It sounds too good to be true. There has to be a catch, right?
This was my reaction when I heard about Robinhood, the app you can download for free and use to start trading stocks with no transaction fees. At the time, most of my retirement savings was in a 403(b) and a state pension. These accounts have limited options, mostly made up of index funds. I am not crazy about index fund investing for several reasons, which I will elaborate on at another time. I had finally opened a Roth IRA with an online broker to invest in individual stocks, but I was frustrated with the fee situation. I investigated Robinhood as an alternative, and here is what happened.
Robbin’ You: The Price of Fees
Online brokers are each built on a system of fees that helps them provide trading services and make a profit. These typically include a fee of $5-10 for every purchase or sale of stock (per transaction, not per share) and larger fees for mutual funds. Some of them also have minimum deposits to open the account or to use certain services. When people say the stock market is “rigged” against individual investors, I disagree. However, it is clear that the brokerage system is rigged against us. Or, at least, it was.
As public school teachers, my wife and I live on a gross household income under $75,000 (that’s before taxes). We don’t have megabucks to invest. I get my state teacher pension, and my employer matches limited contributions to my 403(b). Let’s say I would like save $100 per month in retirement savings on top of that, and I would like access to stocks and funds that are not as limited as my employee retirement plan.
If I deposit $100 into my Roth IRA, and I want to invest it in a stock, I’ll pay a $4.95 transaction fee to purchase $100 worth of stock shares, and I’ll need to pay another $4.95 to sell the shares later. This means that the first 10% of return on the sale of this stock goes to the broker, and I get what’s left after that. If I am buying $1,000 worth of stock, that number goes down to 1%, so the fees have a lower impact if I buy larger holdings of stocks.
If I don’t want to lose substantial percentages of my savings to brokerage fees, I have to purchase stocks in large allotments. That means I’ll have to save $100/month for several months before I have enough to make a practical transaction. Meanwhile, that money is sitting there doing nothing. I guess I could deposit it into a savings account to earn a little interest until I am ready to buy a stock, but the interest rate on that account is below inflation. It will also be tempting to spend that money.
I want to protect my investment from taxes, inflation, brokerage fees, and sometimes even from myself. If I were wealthy and investing gobs of money, I could instantly invest in whatever securities I want at a low fee rate. Since I make a modest income, I have fewer options, and transaction fees have a larger affect on my returns.
I know I am being a brat here, but I want to have the same cake as the rich guy–just a smaller slice of it–and I want to eat it too!
Finally, Robinhood “and his band of merry men” have come along to rob the rich and feed the poor. Actually, they have just made it realistic for an average Joe to benefit from investing in public companies.
How It Works
The Robinhood app concept sounds so good in principle that I wondered right off the bat why everyone hadn’t closed their brokerage accounts and moved to it. There has to be something wrong with it, right?
How Robinhood makes money is the easy part. They collect interest off the uninvested cash in user accounts. They also offer the option of a paid service called Robinhood Gold with extra features. They aren’t making nearly as much money as the brokers charging fees, but they make something.
The more complex question is why millions of investors, including myself, are still paying fees to other brokers when Robinhood makes trading free.
Robinhood has several limitations:
- Limited services compared to most online brokers
- Fewer securities available than most other brokers (no buying individual bonds, OTC market stocks, obscure foreign ADRs),
- No dividend-reinvestment plans (DRIPs)
- No tax-free accounts like IRAs.
These could be a major turnoff to some investors, especially the tax situation. If your taxable income is in the 25% tax bracket, you pay a capital gains tax rate of 15%. So if you sell a stock for a $1000 profit, you pay Uncle Sam $150. If you earn $100 in dividends, you pay Uncle Sam a $15 dividend.
However, if you are in the 15% tax bracket or lower (2016 taxable income lower than $75,300), your capital gains tax rate is 0%. You read that right. It’s zero. Most Americans probably don’t know this, and most probably don’t care. How many Americans with a household income around $75,000 or less earn any capital gains anyway? Some of these people don’t invest at all, as they are living paycheck to paycheck. Those who do save mostly invest in pre-tax accounts like a 401(k) or IRA, where capital gains tax doesn’t matter. However, as we already established, their 401(k) probably has few investment options, and their IRA probably charges a fee on every transaction.
Here is where Robinhood gives the poor man the advantage. He doesn’t have to pay brokerage fees to avoid taxes. Uncle Sam lets him invest without capital gains tax, and Robinhood lets him invest without transaction fees. When I figured this out, I started pouring money into my Robinhood account and buying stocks!
Ideal for a Beginning Trader
Robinhood’s greatest value might be its use as a learning tool. Novice investors often “paper trade” to get experience, “buying” and “selling” stocks with imaginary money. I did this for awhile to get more comfortable, and it was very helpful, but the psychology is drastically different with play money compared to real money, even if the real money is in small amounts.
Without transaction fees, you can practice trading with real money without feeling pressured to buy large volumes. It’s a lot easier to watch a stock plummet 10% when your position is $150 than when it is $1,500 or $15,000. You get the psychological effect of losing money, which is an important experience, but the quantity of money lost isn’t so substantial that you lose sleep over it.
I am still developing my trading strategy. I learn new things every day. Some of the biggest lessons I have learned have been from losing money. I have an investment that is down nearly 10% over a period when the S&P 500 has climbed nearly 9%. The 10% loss drives me crazy, and I really want to see that turn around, but in the end, it’s only $45. $45 could buy dinner and a movie with my wife. It’s disappointing to lose $45, but I’m not going to sleep over it. The lessons I learn from a $45 mistake today might prevent a $4,000 mistake 10 years from now when I am dealing with much larger investments.
How I Use Robinhood
I am not considering Robinhood a retirement account. I use it for long term savings. There may eventually come a day when I will qualify for capital gains tax, so I still want most of my retirement in tax-advantaged accounts. I have some long-term goals that are around 10 years down the road that I am saving for, one of them being a downpayment on a house. I am using Robinhood to earn a higher return on investment toward those goals than a cash account.
I am taking on considerably more risk to chase this return, but I am okay with the consequences if I take losses. Much of risk is about how much time you have. While I call these 10-year goals, they are really 10-year-ish goals. I am not in a hurry to buy a house, so I will take a chance on it taking longer than expected in order to get a higher return on investment.
Think of Robinhood as my bonus savings. I have cash accounts for emergency savings and tax-free accounts for retirement savings. My Robinhood account is a bit like a rainy day fund on top of that.
A Different Approach to Dividend Reinvestment
Reinvesting dividends is the most efficient way to compound your stock returns. You set up a dividend reinvestment plan (DRIP) for a stock you own, and money paid out to you in the form of dividends is automatically reinvested in the stock, rather than being deposited into your brokerage account, where it waits to be reinvested (with another $4.95 transaction fee).
Most DRIP plans allow you to buy fractional shares, rather than having to wait until you have received enough dividends to buy an additional share. DRIP investing is especially good if you use a broker that charges transaction fees because the reinvestment of dividends does not carry a transaction fee.
Robinhood does not support DRIPs. It is disappointing that Robinhood customers can’t take advantage of owning fractional shares to maximize compounding. However, the no-fee system offers other opportunities to reinvest that I really like.
One thing that I don’t like about DRIPs is that if the stock price goes up you are paying more to reinvest. If the stock reaches a price you believe to be higher than its intrinsic value, than your DRIP is spending too much on it. Since Robinhood doesn’t support DRIPs but doesn’t punish you for small transactions, you can apply a slightly different strategy that helps you reinvest dividends and compound fairly well, albeit without the same frequency and efficiency as with fractional shares.
I run screens and research companies to form a watch-list of securities that I am interested in owning, then I keep an eye on that list. When I have cash to invest/reinvest, I ask the following questions about all the stocks on my list:
- Which stocks provide the highest yield?
- Which stocks show the best record of dividend growth?
- Which stocks are available at the best discount right now?
- Which stocks help me diversify better?
For example, a few weeks ago, I was considering adding to my holding of Target (TGT), because it was at a cheaper price than I had paid for the it. It was a good opportunity to increase my high yield. However, I also wanted to diversify more, and there were other securities that would help me do that better. I calculated that Golar LNG Partners LP (GMLP) was selling at a higher discount to its intrinsic value than TGT, it boasted twice the yield, and it allowed me to add my first stock in the energy sector to this portfolio. Opening a position in GMLP met my goals better than reinvesting in TGT. Robinhood made it easy to invest my TGT dividends in GMLP instead.
This strategy is a combination of dividend-growth investing, high-yield dividend investing, value investing, and a focus on diversification, while applying DRIP-like principles without actually setting up a DRIP. It is a best-of-both-worlds strategy that is really only practical with transaction-free trading with no capital gains tax.
For most of the history of stock trading, brokers have catered their services to institutions and high-net-worth individuals. Low-income individual investors got little attention or support (if the broker’s minimum account balance even let them invest at all).
It used to be completely impractical to invest less than $500 in a security because of transaction fees. Robinhood makes it is easy to buy and sell holdings of less than $50 without punishment.
Robinhood lives up to the name and the hype. It is finally giving the low-income individual investor real access to the US stock market. It even gives the low-income investor some trading advantages that high-income investors don’t have.
If you are interested in Robinhood, it does require a little patience up front. Download the app and follow their directions for setting up an account. They will need to verify your identity, run a soft-pull credit check, connect your brokerage account to a bank account for deposits and withdrawals, etc. You won’t be trading the same day you download the app, maybe not even the same week. However, once you are set up and ready to trade, it is extremely easy to deposit money and start putting it to work for you instantly.
Disclosure: I do not have any relationship with Robinhood other than being a customer for 6 months. This is purely a review from a happy customer. I mentioned TGT and GMLP in this article, and I currently hold long positions in both stocks.
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