When the markets crashed in March, many investors were in panic mode, selling off good and bad investments alike. Ultimately, however, the sell-off offered just a brief glimpse as to how bad things could get, as many stocks began recovering just weeks later. In a prolonged market crash, which is what could happen if there isn't a quick end to the coronavirus pandemic, there won't be a quick recovery.
And that could be bad news, especially for Robinhood investors. Here's why they stand to lose the most if the markets go south.
Many aren't investing for the long term
If you're a long-term investor, you're generally looking at where a company you're investing in will be not just months but years from now. But many Robinhood investors aren't taking that approach and are instead looking for quick wins, and that's dangerous -- especially during a recession and when a market crash may not be far away.
Many Robinhood investors are willing to take on high risks in exchange for high rewards in the short term. Hundreds of thousands of investors on the platform are gambling and betting on insolvent companies in the hopes that their stocks will rise in value.
And of course, in the short term, anything can happen. The problem is that if you're caught holding on to the stock of an insolvent business and there's a market crash, you could find yourself with no option but to sell it for a steep loss.
Speculative buys remain popular on Robinhood
Today, many of the top Robinhood picks continue to be airline stocks, including American Airlines and Delta Air Lines, and cruise ship stocks, where businesses are crippled and in danger of going bankrupt. Although they could turn things around, they're definitely high-risk investments.
Cannabis producer Aurora Cannabis (NYSE:ACB) is another high-risk buy that consistently ranks among the top 15 most popular Robinhood stocks. In February, investment bank Ello Capital estimated that Aurora's liquidity levels were among the worst of the Canadian cannabis companies that it evaluated.
The stock was doing so badly this year that it needed a 1:12 reverse split in May just to get back above the NYSE's required minimum $1 share price. Year to date, its shares are down 58%, which is far worse than the Horizons Marijuana Life Sciences ETF (OTC:HMLS.F), which has declined by a more modest 19%.
There are several other examples on the Robinhood top 100 list of stocks that are either risky investments, too richly valued, or both, and where investors are betting on sharp turnarounds. But -- again -- these speculative buys look even worse when the markets crash, as investors look for safer investments to hang onto during a bear market. These already risky investments could plunge even lower during a crash.
Just because a stock's fallen heavily in value doesn't mean it can't continue to go lower.
Value investors are in much better shape
For institutional investors and fund managers who look after other people's money, the types of risks Robinhood investors are taking on are simply unacceptable. They can't afford to gamble away their clients' money, and they need to be much more methodical in their investing process.
That normally involves assessing the value a stock offers and looking at its fundamentals. Aurora would be tough to put in any portfolio where value is important. The Alberta-based cannabis company's incurred an operating loss in each of its past 10 reporting periods. And while its shares may appear to be a deal, trading well below their book value, investors should also recall that Aurora wrote down its assets by 1 billion Canadian dollars ($750 million) when it reported its second-quarter results in February. Relying on book value may not be all that useful if the value of the assets is questionable.
Many top Robinhood stocks wouldn't make it past the sniff test for value investors. With a focus more on value and long-term investing, value investors are at less risk to suffer significant losses during a market crash, and their investments would also be more likely to recover.
What should Robinhood investors do?
The good news is that it isn't too late for Robinhood investors to adjust their portfolios and hold some safer stocks while getting rid of speculative ones. This involves not just looking at valuation multiples but assessing which businesses are safe for the foreseeable future. Determining a company's cash situation and evaluating how it's doing during the pandemic are some ways investors can evaluate the safety and stability of a business during these adverse times.
Hype will eventually die down. And if investors jump on the bandwagons of high-risk stocks, they can be left holding some bad investments in their portfolios, which can lead to all-out disaster if the markets crash.