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Here’s What You Need To Know – Forbes Advisor

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Trading app Robinhood is going public, and its future depends on whether it can evolve to empower fledgling investors to find their inner Warren Buffett or trap them in an unhealthy obsession with speculation and risk.

The Menlo Park, Calif.-based upstart helped transform the brokerage world by pioneering zero-commission stock trading, pushing industry stalwarts like Fidelity, Charles Schwab and E-Trade to follow suit. Its sleek, gamified user experience was known for bursts of confetti after a completed trade—an unfortunate feature that the company is cutting.

After years of steady growth, Robinhood’s secret sauce proved especially compelling during the Covid-19 pandemic, with Americans locked indoors and eager for any way to keep occupied. In an amended filing with the Securities and Exchange Commission, it said it was planning to offer shares at a range between $38 and $42, seeking a market valuation of around $35 billion.

But popularity has also brought controversy. Robinhood recently agreed to fork over $70 million in penalties and compensation to harmed investors based on a settlement with industry self-regulator FINRA that said the investing app distributed false and misleading information to its customers, allowed too many people to engage in risky trading and didn’t properly oversee the technology that supported its app, among other issues.

It has also faced charges of failing to disclose how it makes money and not getting the best price for its customers. At the start of 2021, it has played a central role in the GameStop affair, which resulted in a public grilling of Robinhood CEO Vladimir Tenev in congressional testimony. And now some traders believe Robinhood’s inchoate platform raised their 2020 tax bill.

It’s impossible to say if Robinhood’s stumbles represent the growing pains of a burgeoning behemoth that’s shaking up a staid industry, or whether they portend a painful crack-up down the line. As an individual investor considering the pros and cons of Robinhood’s initial public offering (IPO), proceed with the utmost caution.

Robinhood’s Spectacular Growth Story

However you feel about this online brokerage‘s travails, Robinhood’s rise has been remarkable. From its founding in 2013 until the end of 2020, the platform gained 13 million users. It added another 6 million users in the first two months of 2021.

Robinhood’s marketing mantra is that it aims to “democratize finance.” While that’s mostly marketing hyperbole, it’s struck a chord with customers—especially during the Covid-19 pandemic. Analysts have widely assumed that lockdowns, boredom and government stimulus checks have helped drive masses of new users to the app over the last year. It has even announced that it’s reserving 20% to 35% of its pre-IPO shares for its customers. (Traditionally, average investors are locked out of pre-IPO stock purchases and can only get in on new companies’ stocks after their prices have risen past the IPO level.)

Weekly downloads from U.S. app stores surged in the first half of 2020, making it the fourth most downloaded finance app, according to Sensor Tower—the first time it cracked the top 10.

The average account size is about $3,500, according to market news site Business of Apps, compared to $100,000 for E-Trade and $240,000 for Schwab.

“Robinhood created a really great user and customer experience for millennials to invest with,” said Kelly Rodriques, chief executive of pre-IPO marketplace Forge. “There is a whole generation of investors that are participating in the markets that weren’t there before.”

Despite the prevailing narrative about naive traders buying stocks impulsively, Robinhood’s army of new investors has performed pretty well, at least on the whole. A recent paper by UCLA University Finance Professor Ivo Welch looked at the behavior of thousands of Robinhood traders during the March 2020 bear market as well as over the past three years. He found that traders on Robinhood tended to make sensible moves.

For instance, they continued to buy stocks even as markets declined, setting themselves up to enjoy the new bull market to follow. “They did not panic,” wrote Welch. “Given the subsequent rise in the stock market, their timing and steadfastness contributed to their good portfolio returns.”

They’ve done well over the longer term, too, according to Welch. Between 2018 and 2020 users in aggregate earned solid returns, suggesting that the greenhorns had not been a soft target for sophisticated professionals.

Robinhood’s flood of new customers has made it a subject of intense interest on Wall Street. The company was reportedly valued at $12 billion in September 2020, with that figure rising to about $20 billion by the end of the year, with valuation then doubling to $40 billion in February 2021.

That would value Robinhood as high as one third of the market cap of Charles Schwab, despite having only a tiny fraction of its establishment rival’s assets under management.

Robinhood’s Troublesome Growing Pains

With rapid growth has come growing pains for Robinhood. They can be boiled down into three areas of concern: How the company acquires customers, how it makes money and how it dealt with GameStop.

Berkshire Hathaway Vice President Charlie Munger, Warren Buffett’s 97-year-old investing partner, addressed Robinhood’s troubles at the annual meeting of the Los Angeles Daily Journal (Munger is the media company’s board chairman).

Asked about “wretched excesses” in the financial system, Munger said, “Well, it’s most egregious in the momentum trading by novice investors lured in by new types of brokerage operations like Robinhood. I think all of this activity is regrettable. I think civilization would do better without it.”

Munger is a high priest of value investing, the polar opposite approach to Robinhood’s gamified interface, which many claim is designed to deliver fast dopamine hits with every trade. Tomes of research show that day trading is a very challenging way to make money in investing.

And it’s no accident that Robinhood temps users to trade frequently and potentially take on more risk than they can stomach—sometimes leading to disastrous results. It’s in Robinhood’s interest to churn up trading volume because it earns some of its revenue by selling order flow.

This somewhat obscure business strategy involves a brokerage platform like Robinhood auctioning off its clients’ market orders to high-frequency traders, who pay to fill those orders. The practice is currently legal; however, the Security and Exchange commission is said to be reviewing the practice.

Meanwhile regulators in Massachusetts are looking to ban its citizens from trading on the app, claiming that Robinhood’s gamified investing platform caused its customers to take on too much risk, thereby failing the state’s fiduciary rules.

“[I]t’s really stupid to have a culture which encourages as much gambling in stocks by people who have the mindset of racetrack bettors,” said Munger. “It’s a dirty way of making money.”

Munger’s accusation is exemplified by the ongoing GameStop drama. Individual investors have piled into lightly traded meme stocks, driving some stocks to sky-high valuations based on no fundamental reason whatsoever besides speculation. Robinhood is far from being the only platform used to trade speculatively, but it has certainly become the poster child for the trend.

More recently there have been a spate of complaints regarding how Robinhood handles taxes. A recent Wall Street Journal article highlights problems around “wash sale” rules and “specific-lot identification,” both of which traditional brokerages are able to handle easily without the problems Robinhood has faced.

And then there’s the record FINRA settlement that’s rife with troubling missteps, errors and oversights that call into question whether Robinhood is read for the big time. Some of the complaints, like allowing unprepared investors to get into options trading, are particularly troubling. But some, like when Robinhood displayed inaccurate historical performance figures to nearly six million customers between January 2019 and May 2021, demonstrates…

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