If you’re not yet familiar with the growing interest in online trading apps, you soon will be. Firms like Freetrade, eToro and Trading212 have been busy winning new customers, and, in the next few weeks, the hugely successful American firm Robinhood will start rolling out its services in the UK.
On the surface, trading apps can seem very appealing. The apps themselves are usually very well designed and easy to use. They enable you to buy or sell stocks, cryptocurrencies and other financial assets in a matter of moments.
But is it a good idea to use a trading app? Our view at rockwealth is that they really are best avoided.
Trading is rarely free
The first thing to say about trading apps is that you shouldn’t be fooled by the promise of “free” trading. Remember, these are businesses, not charities, and they exist to make profits. In reality, trading is very rarely free, and there are other ways in which apps make money from their customers so they don’t have to charge an explicit commission.
Another impression the advertisers try to convey is that trading apps will make you wealthy, which is a highly dubious claim. The bottom line is, actively trading anything is not a sensible strategy. The academic evidence tells us that the global financial markets are highly efficient. Identifying, in advance, assets that are going to outperform the broader market is extremely hard to do on a consistent basis.
Bear in mind as well that many of the assets that trading apps give you access to are very risky. Cryptocurrencies, for example, can fall sharply in value very quickly. Some apps also enable you to trade derivatives, which are among the riskiest financial instruments you can buy.
Picking winning stocks is very difficult
But what about stocks? Well, stocks too are inherently risky, but individual stocks are particularly so. When you buy a fund and spread your risk across a large number of stocks, the chances of losing most of your money are slim. But when you buy an individual stock you are pinning your hopes on that one business to generate good returns.
Of course, you might be lucky and buy a stock that will outperform. But research has shown that, in the long run, the vast majority of stocks don’t even outperform government bonds, and your chances of picking, ex ante, one of the very big winners are extremely slim. The worst-case scenario is that the firm you choose to invest in goes bust, in which case you could lose your entire investment.
Trading can be addictive
For some, another danger with trading apps is that they encourage addictive behaviour. A 2013 study by behavioural economists Arvid Hoffmann and Hersh Shefrin showed that around 2.5% of investors behave as if they were addicted to gambling. Hoffmann and Shefrin have also conducted research on investors trading options on sites like Robinhood and found that frequent traders tend to make significant losses.
“In the data which Hoffmann and I use,” Shefrin wrote, “20% of investors trade options actively and 12.5% stipulate that speculation is their primary motive for trading. The intersection, investors whose primary motivation for trading is speculation, and who use options to do so, comprises about 5% of our data sample.
“This group has terrible investment performance, on average earning 27% less per year than investors who are non-speculators, which of course means incurring large losses.”
Someone who has repeatedly warned about the dangers of speculating on the stock market is Warren Buffett. In his latest letter to shareholders in his company, Berkshire Hathaway, Buffett remarked that stock traders are "neither more emotionally stable nor better taught" than when he was a student.
"Markets now exhibit far more casino-like behaviour than they did when I was young,” he wrote. “The casino now resides in many homes and daily tempts the occupants."
In the same letter, Buffett also spelled out just how challenging stockpicking is. “Within capitalism,” he wrote, “some businesses will flourish for a very long time while others will prove to be sinkholes. It’s harder than you would think to predict which will be the winners and losers. And those who tell you they know the answer are usually either self-delusional or snake-oil salesmen.”
Do you really know better than Buffett?
Just think about that for a moment. Warren Buffett is one of the most successful investors of the modern era. He devotes several hours a day to reading company accounts and financial reports to try to identify investment opportunities. Yet even Buffett has failed to beat the market since the global financial crisis. He openly admitted in his latest letter that he doesn’t expect Berkshire Hathaway to reproduce the sort of performance it once did. He has even stipulated that, when he dies, he wants 90% of his money to be invested in a low-cost index fund.
Now, if you think you know more about stockpicking than Warren Buffett, by all means, go ahead and try buying stocks on a trading app. But, unless you have a reliable crystal ball, the overwhelming likelihood is that you will fail to beat a balanced portfolio of passively managed funds.
One more thing: trading apps like to target young people, particularly men, and their advertising can be very seductive. If you have adult children or grandchildren who may be tempted to sign up, you might like to direct them to the InvestSmart section the Financial Conduct Authority website, which provides helpful information on the risks involved.
At the very least, engage them in conversation about it. You could be doing them a huge favour.
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