New Robinhood accounts surged by 30% in the first quarter of 2020. Since then, the world can't stop gawking about all those newbie investors.
The app has become notorious for risky investments and frequent trading that's more like gambling than investing. That said, plenty of people are using the app to invest the smart way. They saw opportunity after March's stock market crash. Now they're using the commission-free platform to dodge the fees previous generations of investors accepted.
Investing on Robinhood or any other platform doesn't have to be a gamble. Here are four things to avoid if you want to invest safely.
1. Buying on margin
Robinhood allows investors to buy on margin, which is tempting when you want to build a portfolio quickly. You use the stocks you already own as collateral to borrow money from your broker to invest more. But new investors are better off only investing with cash.
When everything goes right, margining will amplify your profits. If you invest in stocks with $5,000 of your own money and $5,000 on margin and you earn a 20% return, you've actually earned 40%, minus the interest you pay to your broker.
But what if the stocks you bought drop by 50%? You've lost $2,500 of your own money, plus $2,500 of your broker's money. A 50% loss made you lose your entire investment -- and then some when you account for interest.
Another thing to keep in mind is that your broker is allowed to change the margin requirements at any time and require you to put more equity in the account. If you don't do so within their timeframe -- and they're allowed to make the margin call due immediately -- they'll do a forced sale and liquidate the investments of its choosing to bring you into compliance.
2. Day trading
With day trading, you're betting on short-term fluctuations. True investors look for companies with value that they want to own for the long haul.
There's a huge body of evidence that shows the overwhelming majority of day traders lose money over time. One study found that more than 80% of day traders lose money over a six-month period.
As an individual day trader, you're at an extreme technological disadvantage. Big Wall Street firms use algorithmic trading systems that pick up on fluctuations and patterns long before you, as a human, can.
Plus, stocks are volatile on a day to day basis. On any given day, the odds of stocks making money are about 54%. But investing in large-cap stocks over a 10-year holding period delivers a profit 94% of the time.
If you are one of the lucky day traders who earns a profit, expect taxes to eat away at it. You'll be taxed at short-term capital gains rates, which means your earnings are treated as ordinary income. When you hold an investment for more than a year, you're taxed at the favorable long-term capital gains brackets of 0%, 15% or 20%.
3. Investing because something looks cheap
Robinhood traders have become notorious for chasing cheap stocks -- and those stocks are usually cheap for good reason. Many are penny stocks that trade for rock-bottom prices because the issuing company has no proven track record or is in financial trouble.
Recent corporate bankruptcies have generated some of the most cringeworthy Robinhood picks. The most notorious example, of course, is Hertz Global Holdings (OTC:HTZG.Q), which filed for bankruptcy protection in May. By mid-June, more than 170,000 Robinhood accounts held Hertz stock, up from 1,190 in late February.
While those shares were trading for $1.10 on Friday, Oct. 9, they're likely to become worthless, as common shareholders get paid dead last in bankruptcy proceedings.
4. Trading options when you're new to investing
Retail investors tend to incur substantial losses when they trade options -- and Robinhood traders are doing a lot of options trading. Research firm Alphacution analyzed data from nine brokerage firms for the New York Times earlier this year. It found that Robinhood customers sold 88 times more risky options compared to Charles Schwab customers per dollar in the average account.
Options trading is complicated for beginning investors because there's so much to get right: You're not only betting on the stock's movement, but also the timing of it.
Plus, it's a lot riskier than investing in stocks because in options, there's a winner and a loser. For example, if you buy calls on a stock I own and it starts trading above the strike price, you exercise the option and I have to sell you my stock for less than market price. You win, I lose.
But when you invest in a solid stock, there doesn't have to be a loser. You can sell it at a profit and then the next person can also go on to sell at a profit.
Options can be effective as a hedging strategy, but they shouldn't be used for speculation. And unless you truly understand how they work, avoid them altogether.