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© Source: OpturaDesign / Shutterstock.com Robinhood’s mobile app logo is displayed on a smartphone screen. Robinhood stocks

Apps seem to be doing to the financial system and momentum investing what the cloud has done to technology. They’re breaking it up. They’re creating a new world and leaving the old one behind. But that world is no more honest than the one it replaces.

© Provided by InvestorPlace Robinhood’s mobile app logo is displayed on a smartphone screen. Robinhood stocks

Nowhere is this more evident than with Robinhood Markets, founded in 2013, which runs the Robinhood stock trading app.

But while Robinhood makes it easy for you to buy, say, one-tenth of a share in IBM (NYSE:IBM), it has resisted going public itself. Instead it has raised $2.2 billion privately, most recently through a $660 million round in September. The company now has a valuation of $11 billion with just 56 investors.

Momentum Investing Taking Over the Market

Markets assumed a few years ago that established players, like JPMorgan Chase (NYSE:JPM) or Charles Schwab (NASDAQ:SCHW), could buy out the fintech industry and maintain control of the system.

That’s proving impossible. New banking and brokerage companies, built connecting simple apps to existing banking systems, are remaining under venture capital control until they reach valuations big players can’t afford.

For instance Schwab, which just finished buying TD Ameritrade for $22 billion, currently carries a market cap of $70.5 billion. Buying Robinhood even now would represent significant dilution. Instead Schwab is trying to copy some of what Robinhood does by selling fractional shares, which it calls stock slices.

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It’s not working. Robinhood now executes 4.3 million trades a day, almost as many as TD Ameritrade and Schwab combined. They do it by selling their order flow to professional traders, who profit from being on the other side of the trade.

What can be wrong with that?

Skinning Young Cats

It’s dangerous because Robinhood doesn’t just sell stocks. Robinhood began trading cryptocurrencies in 2018. It also trades options, where investors can quickly lose more than their initial stake. If you sold Tesla (NASDAQ:TSLA) short as its price skyrocketed early this year, you understand the risk. Now imagine if you sold short with no clue about the risk.

Robinhood’s marketing encourages young, inexperienced investors to trade heavily, with fractional shares, no fees, and products built with high risk. Critics say it steals from the poor and gives to the rich. 

The get-rich-quick mentality of Robinhood traders is easy to take advantage of. The most popular stocks there among those traders as this was written were Virgin Galactic (NYSE:SPCE), a $5 billion space plane company that has no flights, and Catalyst Pharmaceuticals (NASDAQ:CPRX), a $340 million drug company that has no drugs.

I wrote about this kind of trading mentality in Salon 20 years ago. This was a few months before a trader killed nine people in an office blocks from the one I had visited, then killed himself.

You can’t beat the house, and you can’t beat the machines. The best way for the small investor to make money is to buy good companies and let time do its work.

The Bottom Line

Every market has its stories of excess, of small players getting taken and of greed taking over.

Momentum investing with Robinhood is just the latest iteration.

The question for you is whether the company behind the trend has legs. The day trading companies I covered, which rented computers and fast data lines in 1999, were gone by 2002. When investors get smart about how to make money, the value of Robinhood’s order flow will fall, and Robinhood will have to adapt.

When Robinhood does decide to IPO, a lot of smart people are going to tell you to buy. I won’t be one of them. The smart people will, at that very moment, be selling.

Dana Blankenhorn has been a financial and technology journalist since 1978. He is the author of the environmental thriller Bridget O’Flynn and the Bear,  available at the Amazon Kindle store. Write him at danablankenhorn@gmail.com or follow him on Twitter at @danablankenhorn. As of this writing he owned no shares in companies mentioned in this story. 

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