The Hidden Cost of Free

The idea of getting something for nothing seems too good to be true. And as the saga of Robinhood Markets Inc. has shown, it often is. The popular trading app that promised to democratize finance by offering commission-free trades has become a textbook example of Morgan Housel's wisdom: "Everything has a price, but not all prices appear on labels."

Robinhood's meteoric rise was fueled by a simple promise: zero-commission stock trades. To the average investor, this seemed like a dream come true. No more pesky fees eating into their returns. But as the old saying goes, there's no such thing as a free lunch, and Robinhood's business model revealed the hidden costs of "free" trading.

The company's primary revenue stream came from a practice called payment for order flow (PFOF). In essence, Robinhood sold its users' trade orders to high-frequency trading firms. These firms would then execute the trades, often at prices slightly less favorable to the user than they might have gotten elsewhere. The difference, small on individual trades but substantial in aggregate, was how Robinhood made its money.

This practice is like a grocery store offering "free" shopping, but making its profit by selling your shopping list to a third party who then slightly marks up the prices of the items you buy. You might not see the cost on your receipt, but you're paying it nonetheless.

The true price of Robinhood's "free" trades became apparent during the GameStop frenzy of early 2021. When trading volumes skyrocketed, Robinhood found itself unable to meet its clearinghouse deposit requirements and had to restrict trading on certain stocks. Many users, unaware of the complex financial machinery behind their "free" trades, felt betrayed.

This situation is akin to discovering that the "free" buffet you've been enjoying actually has a cover charge that's collected when you leave – and on busy nights, some dishes might be off-limits to manage costs.

The Robinhood case illustrates a profound truth about investing and life in general: nothing is truly free. There's always a cost, whether it's visible or hidden, immediate or deferred. In Robinhood's case, the cost was in potentially less favorable execution prices and increased risk during market volatility.

Always look beyond the surface. When something seems too good to be true, it probably is. The real price might not be on the label, but it's there, waiting to be discovered by those willing to dig a little deeper.

This doesn't mean that innovations like commission-free trading are bad. They've undoubtedly made investing more accessible to many. But it does mean that we need to be more discerning consumers of financial products. We need to ask: If it's free, how is the company making money? What am I giving up in exchange for this service?

If you're not paying for the product, you are the product. So next time you're offered something for "free," take a moment to look for the price tag. It might not be visible, but rest assured, it's there.