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Writer's picturetomrimer

There's No Free Launch

You’ve already heard the saying, a million times I’m sure, that there’s no free lunch. It turns out there’s no free launch either.

Before you start wondering whether I have either just been hired by NASA or finally gone stir crazy, I’ll tell you what I mean: many students have talked to me about launching their investment portfolios by buying a single stock using apps like Robinhood. Without repeating recent posts I’ve made on the subject, I’ve always said I think it’s a great way to get started, but eventually a diversified portfolio (preferably made up of mutual funds) would also be a good idea.

And the great thing about Robinhood is: it’s free! What could be better than free? But is it really free? They don’t charge commissions, and there are no fees to open or maintain an account. One day after class, a student asked me, if everything is free, how does Robinhood make any money? Great question!

Not knowing the exact answer, I told my student that I assume they probably sold stock for slightly higher than the market price, and bought stock below the market price. Recently I found out that’s not how they make their money. Actually, they make most of their money not directly from clients, but from brokers who make their transactions for them.

At a basic level, here’s how it works: Robinhood, and apps/services like it, take buy and sell orders from clients, but they do not make the actual buy and sell transactions (usually called “trades”) themselves. A brokerage firm makes the trades for them on the market (sometimes known as trading brokers or market makers), and they pay Robinhood (we’ll just use Robinhood as an example for the rest of this post) for this service.

Wait a minute…the trading brokers pay Robinhood for doing Robinhood a service? Shouldn’t Robinhood pay them? Yes, if Robinhood wanted to go broke in no time flat. The reasons brokerage firms pay Robinhood for this service instead of vice versa is that the trading brokers themselves make more money from the trades Robinhood sends them than Robinhood does. And why not, these are all businesses, not charities.

So how do the trading brokers make their money? Largely in the way I thought Robinhood was making theirs. I won’t go into the details of how stock transactions work (there will be a blog post on it next week though), but they make a profit based on the difference between a stock’s “bid” price, or what they are willing to buy the stock from clients at, and the “ask” price, which is what they sell stocks to clients for. This difference is called the “spread”, and it’s been a way for brokers to make their money since the stock market began.

Where these trading brokers really clean up though is on options trades, which tend to have much larger spreads than stocks do. Options are the topic of my next post, so if it’s something you’re interested in, it will be available soon.

Another way Robinhood adds to its sharply increasing profits is on cash sitting in customer accounts. This is another standard practice among all brokerage apps/services (and banks, for that matter): they pay customers very low rates of interest on cash balances in accounts, and then loan the cash out (in the form of margin loans) at much higher interest rates. Not a bad business to be in!

Neither Robinhood nor the trading brokers are doing anything wrong; in fact, what they are doing is legal, ethical, moral, and a rather good business model. My purpose with today’s post is not to tell you there is something wrong with Robinhood or the other brokerage apps; in fact, I think Robinhood is a very good way to get started in the stock market.

The point that I am trying to make though is: don’t think their service is free. While I think Robinhood is a fine app, and there are many others out there with the same type of setup/business model, I want people to always be mindful of what their costs are. Fees are everywhere, which in most cases are fair and make sense. But always take into account your total costs when making investment decisions. This will become a lot more relevant when we talk about mutual funds. Always know where your money is going, even when something looks free.

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