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Robinhood Investors Might Be Violating Basic Allocation Rules

By Ryan Downie – Oct 15, 2020 at 6:03AM

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The stocks owned by the highest number of Robinhood users have mostly lagged the market since April, and the top performers might be too volatile to celebrate.

Data indicates that Robinhood users, who are frequently learning how to invest in stocks, are piling disproportionately into a small number of risky strategies that violate important portfolio composition principles. The most popular stocks on the platform illustrate some clear purchasing trends that have yielded mixed results over the past six months.

However, even in those cases that have delivered favorable returns, a more nuanced analysis shows that investors may have taken on too much volatility to justify those gains.

Smiling man on laptop outside

Image source: Getty Images.

Robinhood became a lot more popular in April

Working from home and volatile market conditions fueled stock market participation in 2020, and Robinhood was one of the main beneficiaries, seeing its active user base grow from 10 million at the start of 2020 to 13 million in June., a site that published data from Robinhood's API through August, allowed the public to see which stocks were held by the largest number of account holders. This data didn't weight holdings according to value, but it still gave a great idea of the general trends that have been motivating retail investors and traders.

From April through August, the 10 most popular stocks on Robinhood remained largely unchanged. The list is comprised of GoPro (GPRO 0.95%), Carnival (CCL 4.61%), Tesla (TSLA -1.14%), Delta Air Lines (DAL 2.19%), Walt Disney (DIS -1.04%), Microsoft (MSFT -0.59%), Apple (AAPL -2.12%), American Airlines (AAL 2.24%), General Electric (GE 0.22%), and Ford Motor (F 0.15%).

Robinhood investors are targeting momentum and deep value

Since activity started taking off in April, half of the top 10 stocks on Robinhood have been outpaced by indexes that investors can track easily, inexpensively, and in a diversified manner with exchange-traded funds (ETFs). Investors have targeted deep value in airlines Delta and American, while powerful brands GE, Disney, and Microsoft have also generated attention.

Among that group, only GE is down over the period, but investors would still have been better off simply owning the market than half of the Robinhood top ten stocks. The long narrative for these five stocks may well come to fruition in the near future, but holders have nonetheless incurred six months of opportunity cost during one of the hottest bull markets of all time.

Stock price chart for the S&P 500, Delta Airlines, American Airlines, GE, Disney, and Microsoft from April to October 2020.

Image source: YCharts.

Elsewhere in the Robinhood top ten list, investors are enjoying some high-flying winners, including Tesla, Apple, GoPro, Ford, and Carnival. These were great positions to ride during the current bull market, but the ownership data indicates that the vast majority of Robinhood investors were still holding these stocks without taking all those gains off the table as of August. Holders of these stocks should congratulate themselves on these wins and know that they've outperformed benchmark indexes. However, they should also be aware of associated volatility risks and some absolutely essential portfolio composition principles.

Stock price chart for the S&P 500, GoPro, Tesla, Apple, Ford, and Carnival Cruise Lines, from April to October 2020

Image source: YCharts.

Returns are an essential aspect of performance, but not the only one

Lagging performance for half of the top ten list speaks for itself, and the investing community no doubt wants to see that number higher. Beyond that, it's easy for investors to fall victim to confirmation bias and ignoring process in favor of results when assessing the surging portion of the portfolio.

All five stocks in the top ten that delivered outperformance are relatively volatile names with five-year beta values ranging from 1.3 to 1.95. This shouldn't be surprising, because volatile stocks tend to deliver better returns during bull markets. There's absolutely nothing wrong with owning volatile stocks. It's important to have exposure to these sorts of positions in a growth portfolio, because they are engines for gains. However, volatility works both ways, and overweighting these equities can quickly eliminate returns when the market sours. Robinhood users had not exited these positions as of August, so an examination of risk-adjusted returns could be vital for those investors.

Long-term investing is based on business fundamentals, stock valuation, and a stock's performance outlook relative to others. Speculation, on the other hand, largely ignores fundamentals by shifting the focus to narrative guesswork and momentum. Speculators sacrifice some control over performance, and they usually rely on short-term market dynamics working in their favor. Meanwhile, fundamental investors know that long-term stock performance will reflect the financial results of the underlying company. Along the way, share values may fluctuate within any short-term window due to market dynamics, and this risk can be quantified with volatility metrics such as beta.

As a result, sophisticated investors often analyze returns relative to volatility, thus ensuring that gains aren't simply a result of riskier behavior during advantageous periods. The Sharpe ratio is a popular metric used for this purpose. It's not a flawless metric, but it can shed some light on performance. Indeed, Robinhood's highfliers look somewhat less exciting in this light. GoPro's 1.95 Sharpe ratio and Carnivals' 0.78 are outstripped by 2.98 for the S&P. Tesla's 3.34 is almost identical to that of the NASDAQ. Ford and Apple still look to have been worth the volatility at 3.91 and 3.41 respectively, but the gap between those stocks and simple index fund is much more narrow once returns are risk-adjusted

Hopefully, the swelling number of Robinhood accounts represent the speculative or playful portion of users' overall financial plans. If these are their primary equity holdings, they would be well-served realize some gains, diversify and consider the role of volatility in whatever returns they've delivered so far.

Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Ryan Downie has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple, Microsoft, Tesla, and Walt Disney. The Motley Fool recommends Carnival and Delta Air Lines and recommends the following options: long January 2021 $60 calls on Walt Disney, long January 2021 $85 calls on Microsoft, short January 2021 $115 calls on Microsoft, and short October 2020 $125 calls on Walt Disney. The Motley Fool has a disclosure policy.

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