The brokerage app Robinhood got popular offering supposedly ‘free’ stock trading and encouraging its clients to gamble by trading rapidly in hype-driven ‘meme’ stocks like Gamestop. I’m here to tell you these trades are definitely not free and are costing Robinhood’s investors hundreds of millions of dollars per year collectively, without their even knowing it. (Specific dollar amounts per brokerage and security type here in case you’re interested.)
Payment for order flow (PFOF)
How does Robinhood swindle you without you ever knowing? They use an evil practice that many brokerages (but NOT Vanguard!) use to make extra money off their clients without the client ever knowing. Robinhood gets to choose which market marker actually executes the stock trade you place on Robinhood. A good brokerage will choose the executing firm based on how fast the trade will execute as well as getting the best price for their client. Instead, Robinhood actually benefits from giving you a worse price because they get the executing firm to pay them in exchange for sending them your order to execute. The market maker/trade executor will either has a lousier bid-ask spread than a better partner, or they won’t let you benefit from ‘price improvement’.
Sorry, no price improvement for you!
Price improvement is when you order a trade to buy at one price, but then you would actually be able to get it at a slightly lower price, saving you money. A good brokerage firm would pass the savings a long to you, but Robinhood will instead keep some of that and split it with their market maker that they route your trade to. For example, you might place an order to buy 10 shares of XYZ at $200 a share, but a good brokerage like Vanguard might get you 10 shares of XYZ at $199.50, saving you $5 ($0.50 price difference per share * 10 shares.) Robinhood and their partner might just keep that $5 between themselves, and only give you the $200 price you entered the trade at.
Making money off PFOF is a huge conflict of interest between your brokerage, Robinhood, and you. Robinhood uses PFOF to steal little bits of your trades while telling you they are ‘free’. That’s enough reason to never use Robinhood again, but they have another glaring defect too.
No tax management ability
A good brokerage like Vanguard will make it easy for investors to manage their capital gains taxes by letting you sell specific shares of a given stock or fund. If you’ve purchased a stock or ETF or mutual fund over time, different purchases will trigger different amounts of capital gains*, and smart investors sell the ones that generate the least taxes (or even save on taxes by selling losers before the end of the tax year. This is know as ‘tax loss harvesting’, which I do myself to offset my capital gains, or save a little by having a capital loss for tax purposes.)
Robinhood makes it impossible to sell specific shares online. Apparently there is a convoluted way to do this over the phone or via email, but hardly anyone is doing this at Robinhood, or is willing to for the hassle. Vanguard makes it easy, as do all other reputable brokerages.
So, avoid Robinhood like the plague! Transfer your account to a good brokerage like Vanguard. (Fidelity is fine too if you already have assets there and don’t want to use Vanguard, and they do NOT accept PFOF either, which is great. Many other brokerages do have the evil PFOF conflict of interest, so avoid them.)
*For example, maybe you own 5 shares of AMZN and want to sell two of them because you need $7,000 in cash. Two of your shares were purchased a year ago for $2,000, and the other three were purchased a few years ago at $1,000 each. If you sell the two shares at $3,300 per share with the cost basis of $2,000 you'll have a capital gain of $1,300 each, which at 15% capital gains tax would cost you $390. At Robinhood, you can't choose the lower-tax shares, and you'd pay your average gain on all five shares, which would be a cost basis of ($2000*2 + $1000*3 / 5) = $1400, making your capital gain per share $1900, resulting in total taxes of $570, costing you $180 more bucks, an increase of 46%, in taxes.