Andrew here, guest writing on The Margins today. Today, we talk about a product that works well and why that might be...bad for us?
I work in academic economics. In economics, there is a standard story for how competitive markets work and why that is, on net, good for society. The story goes like this: for any good or service (let’s say apples), there is demand (people want to consume it) and supply (people and companies make it because they can economically profit from it). The suppliers are incentivized to make apples that are superior (taste better, are less likely to go rotten, etc) or cheaper to beat out their competitors, and so they will attempt to make their apples ‘better’ from the standpoint of the consumer, and they will innovate to do so. This means that consumers will get better/cheaper apples, and this is good and desirable.
There are ways that a market can go wrong, such as what’s called an ‘externality’ (ex. a company can drill for oil), which we want, but as a side effect that isn’t fully taken into account that oil will release fossil fuels into the atmosphere, which is bad. But for the most part, if a company is innovating to provide a product that is superior to existing alternatives in terms of quality or cost, this is a market-level improvement.
(image from Disney)
Keeping that in mind, I want to talk about a company called Robinhood that has won awards for innovation. Robinhood is an app that enables you to trade securities (stocks, ETFs, options, etc) commission-free. This means that you can link up your money and buy, say, 100 shares of Walmart using Robinhood and it will not charge you any money for providing that service.
How significant is this? Robinhood’s valuation is reportedly around $7 billion and growing fast. About half of Americans have wealth in the stock market in some way, usually through a retirement/pension fund, and about 14% own stocks directly and 7% say they trade stocks and other funds “regularly.” These are millions of people who are known in finance as ‘retail investors’- individuals who aren’t professional investors or investment institutions like mutual funds, endowments, etc.
And before Robinhood, these people were paying through the nose to move their money. For example, Fidelity, a large financial services company, says it provides “industry-leading value” by charging you… $4.95 per trade. And lots of firms charge way more! This is Ticketmaster-level extraction from consumers while the actual cost of executing most equity trades is only a tiny fraction of this fee. These dinosaurs absolutely deserve to be disrupted. So it must be a win for society that Robinhood’s commission-free trading service is grabbing market share from them...right?
There is one catch: Robinhood makes revenue from routing your trades to high-frequency traders in exchange for a fee, which might mean that you’re not getting the best available price for a security in the market at any given time (Robinhood says “we send your orders to the market maker that’s most likely to give you the best execution quality”).
But there’s a more fundamental problem, which is that you, a retail investor, shouldn’t be trading stocks, and Robinhood is making it easier for you to do something you shouldn’t do.
You Know Nothing, Jon Snow
For a long time, one of the biggest stories in finance has been the rise of index funds, which are funds that do not attempt to outperform the market as a whole, but simply hold securities from across the market and so perform at the aggregate market’s level. Why would this be desirable?
It is desirable because of an oft-misunderstood theorem called the efficient market hypothesis, which at its simplest level goes like this: the price of a security like a stock reflects the market’s consensus of how much that security is worth. That means that if you, retail investor, try to pick stocks to try to outperform the market, you are making a bet that you are better able to understand the trajectory of that stock than the collective knowledge of everyone else who is also trying to do the same thing. That you would be correct in this bet is highly unlikely, and it is highly unlikely for every other individual actor as well.
It is so unlikely that you know better than the market that full-time, professional investors who spend their lives trying to know better show over and over that they are incapable of doing it. When over 90% of actively managed funds underperform the S&P 500 (net of fees) over a 15-year period, it is easy to see why the new behemoth in terms of assets under management is original index fund popularizer The Vanguard Group (disclaimer: I have a Vanguard Roth IRA account). Vanguard’s strategy is very simple: instead of charging you through the nose to pay people to pick stocks that mostly do worse than just buying all of them, it charges at cost to buy all of them.
And of course, while index funds outperform people like the hedge funds and mutual funds, retail investors do even worse than the pros, with the retail investors who trade the most frequently doing the worst of all. At a certain point a retail investor making a lot of trades without sophisticated knowledge becomes straight-up gambling, and by definition these people are going to a very disproportionate share of the trades on Robinhood and other platforms. And while a good portion of the reason retail investors perform so poorly is because of the trading fees that Robinhood eliminates, it is still the case that people would be much better off buying an index.
The Efficient Market Hypothesis (2019, colorized) (from Giphy)
Hold Me Back
So we hit a paradox. Robinhood is unquestionably a leap forward in business; it has leveraged an efficiency to strike at an oligopolistic brokerage cartel that has been charging its customers obscene amounts of money to perform a low-cost service. But this same improvement actually reduces the disincentive to trade, which is something that reams and reams of social science tell us people should not be doing. Robinhood’s incentive structure is that it wants you to trade on there as much as possible. Real people hurt because of this (personally, a relative of mine lost a great deal of his savings day trading, which caused substantial strain on the family).
This is not supposed to happen. It is not supposed to be the case that a market innovation that people want and decide to use over often objectively worse competitors might not lead to an improvement in people’s lives. This is not an externality problem of some side effect that people insufficiently factor into their decisions; this is the core product consumption.
The case of Robinhood is disturbing because it calls into question the premise of the happiness-enhancing market: that consumers making their own decisions, without the problems of externality or monopoly, will lead to the best outcome. It is hard to confront this problem without going down a slippery slope, and while there are various ‘nudges’ and regulations that I would consider to be helpful for this specific situation, I think it’s more interesting to think about how this should push us to adjust our priors with regard to innovation. It suggests that we should be more cautious about whether even objective technological or business improvements translate into improvements in our lives.
This does not mean that Robinhood has no use cases! There are all sorts of reasons why someone would want to have a particular security that is not part of an overarching day trading or investment strategy. I’m impressed with their product, and impressed with the entrepreneurial gumption to take a whack at a powerful industry and refuse to buckle. Robinhood is an example of exactly the sort of thing that economists have in mind of innovative competitors lowering costs for better services and getting rewarded with market share.
The problem is that this existing framework of evaluating contributions doesn’t always seem to work.
What I’m Reading
The I In We: this profile of The We Company (you probably know it as WeWork) and its co-founder and CEO, Adam Neumann, drives home that WeWork is a sort of singularity for the ~ cool company ~ ideals and reality of 2019: filled with ostensible social progressivism, WeWork’s main business objectives are to grow as fast as possible while dodging organized labor, generating a cult of personality around itself, and get some self-dealing on the side. One of the many passages that gave me heartburn:
Building community is what WeWork has always promised, and its pitch to large corporations is not just hip design and flexible leasing terms but what WeWork calls its “WeOS,” referring to its expertise in helping companies optimize both space and overall culture. (In 2017, McKelvey was named WeWork’s chief culture officer, and he’s fond of using one of WeWork’s many internal slogans: “Operationalize Love.”)
Clarence Thomas’ Counterrevolution: professor and writer Corey Robin’s book, which is based on this article, is coming out soon, and it’s one of the few ‘actually, everyone has been missing something big/thinking about it all wrong’ takes I’ve read that not only seemed genuinely argued but convinced me of its correctness. Ultraconservative Supreme Court Justice Clarence Thomas is most famous for being the only black person on the Court, allegedly sexually harassing Anita Hill, and almost never speaking during oral arguments. Robin does a deep dive into his public statements and opinions and theorizes that Thomas follows a consistent jurisprudence of a strain of pessimistic black nationalism and separatism:
Unlike many in the Black Power tradition, or even in the black conservative tradition, Thomas seems never to have developed a political or economic analysis of racism. His is primarily a moral account of racism. Racism is shape-shifting, often hidden; that is its poison. The antidote to racism, the moral answer to it, is race sincerity: being truthful with and to oneself, and seeking truth, in however malignant a form, in and from one’s enemies.