Should Robinhood Investors Worry About Charlie Munger’s Criticism?

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If you’re a new investor who uses the red-hot Robinhood brokerage app, you may have been surprised by comments from Warren Buffett’s partner Charlie Munger on Wednesday. Speaking at the Daily Journal Corporation annual meeting, Munger criticized what he viewed as rampant and ill-informed speculation in the market right now, done by people “who have the mindset of racetrack bettors.”

Munger also specifically called out new brokerages, mentioning Robinhood specifically, for encouraging dangerous behavior. “It’s a dirty way of making money,” Munger said.

For its part, a Robinhood spokesperson called Munger’s comments “disappointing and elitist.”

If you’re a new investor and use Robinhood or another “free trade” brokerage app, should you be worried about Munger’s criticism? Is Munger even correct in his assessment of the market and in laying some blame at Robinhood’s feet?

Image source: Getty Images.

Mungerism at a glance

This is not the first time Munger has called out rampant speculation in the market. A few years ago, well before the GameStop saga and SPAC-a-palooza of 2020-2021, Munger called out the “wretched excess” he observed throughout markets and the financial system. Munger has also called out Wall Street for the rampant greed that caused the housing bubble and crash of 2008, the tech bubble of 2000, and others before then — after all, Munger has seen a lot of exuberant markets and downturns in his 97 years. He doesn’t mince his words.

Remember, Buffett and Munger are value investors, and both exert extreme discipline and caution when making investments. They follow the teachings of Buffett’s teacher and mentor Benjamin Graham, who said, “Investment is most intelligent when it is most businesslike.” Munger views prudent investing as owning shares of a business and holding for the long term, not riding waves of momentum to make lots of money very quickly, which is the behavior he’s observing today.

That philosophy has certainly served Munger well, as his long-term investing record has borne out. We here at the Fool also preach the virtues of long-term investing and view it as owning pieces of great businesses that can compound value for years.

Munger’s problems with Robinhood

Of course, financial bubbles and stock market mania existed well before Robinhood. So why is Munger picking on Robinhood specifically? A few possible reasons stick out.

Possibly deceptive marketing: Robinhood aims at younger, newer investors by offering “free” trades. The free trade concept it pioneered was such a big hit that other established discount brokerages eventually followed suit and lowered their commissions to zero in 2019.

The catch? Robinhood’s trades aren’t exactly “free.” Robinhood sells order flow to high-frequency traders, who “make markets” by buying and selling shares at very close prices. Although the process is somewhat technical, the takeaway is that traders on Robinhood likely get worse price execution than they otherwise would at other brokerages with paid commissions. The commission isn’t necessarily “free,” just “hidden.”

“Gamifying” what should be “businesslike”: As a millennial-focused app, Robinhood incorporates a number of features aimed at making investing exciting and fun. Unfortunately, excitement and fun can often lead novices astray in investing, with dire consequences. In December, the Massachusetts Securities Division filed a complaint against Robinhood, accusing it of using elements of video games in its investing app. Examples include push notifications and raining down digital confetti when someone makes a trade, among many other features that regulators thought encouraged excessive trading — which benefits Robinhood.

Easy margin loans: Robinhood also offers traders margin loans at very low interest rates. According to its website, those with accounts over $1,000 can get a margin loan at just 2.5%. That’s lower than most brokerages out there. Some might ask, “What’s the problem?” Indeed, a lower interest rate is obviously beneficial to the investor who uses margin. However, those super-low rates can also lure new investors into making trades with borrowed money — a dangerous practice. If you buy stock with borrowed money and the price falls far enough, your brokerage can liquidate your stock to cover the loan, leaving you with an unrecoverable loss.

Analysts estimated that in 2018, the average Robinhood account was between $1,000 and $5,000 — far behind other brokerages. That may indicate Robinhood investors are newer to the game, and buying on low-cost margin may be too tempting for many to resist.

Image source: Getty Images.

In Robinhood’s defense

Of course, Robinhood didn’t invent the sins of greed and speculative excess. That’s part of human nature and financial markets. I’d guess that seeing a stock go up 10% or more in a single day on a trading screen — no matter what brokerage you use — is probably more exciting than seeing a confetti emoji. Robinhood wasn’t around in 2000 or 2008, but the tech and real estate bubbles still inflated and burst.

Additionally, there’s always a tension between opening up investing access to more people versus protecting these same investors. For instance, investing in certain investment vehicles, such as private equity, venture capital, or hedge funds, has traditionally only been available to accredited investors, meaning those with a large current income or amount of net assets. The rules were designed to protect those with less knowledge and less of a financial cushion from investing in “risky” financial instruments. However, it also shut a lot of investors out of an asset class that has the potential to generate outsized positive returns. Many have called on financial regulators to relax those rules in the name of equality for those who aren’t super-rich.

Certainly, Robinhood has been effective at bringing in a new generation of investors with less spending power (or “democratizing” investing, as management puts it), and that can be commended. However, the app should also take precautions to make sure it’s providing as safe an investing environment as possible and not promulgating excessive risk-taking and trading.

A checklist for Robinhood investors

If you are new to investing and using Robinhood, you’re not doing anything wrong, provided you’re OK with perhaps getting inferior price execution in return for free trades.

However, while investing, it’s probably a good idea to ask yourself the following questions before making trades, including:

  • “Do I really understand the business behind the stock I’m buying?”
  • “Am I buying this stock because I believe it’s undervalued in relation to its future business prospects, or just because its price has been going up?”
  • “Would I be comfortable holding this stock for years, or am I too readily excited by daily price action?”
  • “Am I using a prudent amount of leverage, or better yet, no leverage at all? Am I aware of risk as well as potential return?”

If you’re honest with yourself and can answer all of these questions with confidence, then there’s nothing wrong with using Robinhood, or any other trading app. After all, a brokerage is just a means to invest in stocks and other investment products. Ultimately, the onus is on the individual investor to educate themselves and do so responsibly.

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Billy Duberstein owns shares of GameStop and has the following options: short April 2021 $35 calls on GameStop, short April 2021 $50 calls on GameStop, and short April 2021 $125 calls on GameStop. His clients may own shares of the companies mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.