Recent events have placed retail investors firmly in the limelight when it comes to the world of investing. As well as driving a rise in trading volumes, these investors use leverage, buy and sell speculative options on specific companies, and take to social media to better coordinate their portfolios with fellow investors.
There have been signs of the growing influence of retail investors for some time now based on patterns in equity trading volumes and stock price movements. For instance, individual investors are generally more attracted to the speculative potential of single stocks, rather than the rich diversification benefits of indices.
Alongside the importance afforded to speculative stocks, share turnover for ETF (exchange-traded funds) tracking and the S&P 500 has flattened in recent years whilst tracking of the S&P 500’s individual companies have been on a consistent upward trend over the same period of time – indicating that 2017 may have been the year that this new influx of retail investors began to make their presence felt.
Retail investors are also more likely to trade assets based on factors aside from their fundamental information. This shows some similarities to the dotcom boom in the late 1990s where investors would react to important news about certain companies by buying shares in similarly named but different firms. This pattern is clearly evident in 2021, and we’ve already seen investors mistakenly send the value of Signal Advance shares rose by 438% following an Elon Musk message on social media to “use Signal” in reference to a messaging app that has nothing to do with the company or its stock.
Make no mistake about it, we’re entering the age of the retail investor. In a market that’s been heavily punctuated by institutional investors, retail is beginning to gain ground in the battle for market dominance. But what actually is a retail investor? And what’s the difference between them and their institutional counterparts?
Let’s take a deeper look into the world of retail investors, how they behave, and how they’ll change the financial landscape for good:
What are Retail Investors?
First thing’s first. Let’s explore who retail investors actually are. Generally speaking, the term retail investor refers to somebody who makes investment choices for their own accounts or those who have investment decisions made on their behalf.
(Image: Financial Times)
As the chart above shows, the Covid-19 pandemic has led to a significant spike in retail investment towards trading volumes that have never been seen before. This has been fuelled by government stimulus packages and the money-saving impact of national and local lockdowns. Although this data is from the US, the trend is spreading across the world and has led to more instances of unexpected squeezes on stocks based largely on sentiment.
For instance, January saw a significant short squeeze occur on GameStop stocks thanks to investor coordination through the Reddit group r/WallStreetBets before retail investors flocked to popular trading apps like Robinhood to send GME shares rocketing by 4,600% at its peak.
However, retail investors are about much more than meme investing, and the term can be broken down into three different types of investor:
- Individual investors who use a retail brokerage or other types of investment accounts that they’re in control of. For instance, Robinhood or TD Ameritrade are popular options that empower investors to explore and purchase stocks and other investment vehicles for their portfolios. This can also apply to individuals who participated in crowdfunded private equity investments through their own accounts.
- Individuals who have account managers who make investment decisions on their behalf. For instance, if you pay a financial planner to oversee your investment portfolio and to make informed key buy and sell decisions based on their experience for your account. Despite not being in the driving seat, you’re still very much a retail investor.
- Groups of individuals who choose to pool their money to make stock investments or to share their investment decision power. While this form of retail investor is similar in essence to that of an institutional investor, the big distinction is that the investment decisions made are designed to benefit individuals – rather than corporations or other larger entities.
Generally speaking, retail investors tend to invest small amounts of money in comparison to hedge funds, which can pump hundreds of millions of pounds into the stock market in one fell swoop.
For retail investors, their investments typically extend to £100s or £1,000s in scale. This has led to some defining retail investors as ‘small investors’ but there are exceptions to this trend, and retail investors don’t necessarily have to be using a small account value in this regard.
In a nutshell, retail investing means making investment decisions for individual investors, rather than corporations, organisations, funds or other large entities.
How Retail Investors Operate
Retail investors typically buy and sell trades in the equity and bond markets. They also tend to invest far smaller amounts than large institutional investors. However, wealthy retail investors can potentially access alternative investment classes like private equity and hedge funds. Due to their smaller levels of purchasing power, many retail investors are required to pay higher fees or commissions to broker their trades, although increasingly online brokers are working to eliminate fees for small scale trades.
The SEC (Securities and Exchange Commission) is tasked with protecting the interests of retail investors to ensure that markets function fairly for all. It’s the SEC’s job to protect retail investors by providing better education and the enforcement of regulations to ensure people remain comfortable and confident when investing in markets.
Although retail investors don’t possess the same levels of funds as their institutional counterparts, they have a profound impact on market sentiment, which helps to set the overall tone across financial markets. Predictors of investor sentiment can include mutual fund flows, the first-day performance of IPOs, and data from the American Association of Individual Investors – which exists to look into what retail investors expect within the markets. Metrics surrounding retail sentiment is tracked by reputable stockbrokers like E*TRADE and TD Ameritrade.
Understanding The Differences Between Retail and Institutional Investors
So, now we’re aware of how retail investors behave in the stock market, let’s explore the differences between them and the larger institutional investors that have traditionally controlled the markets.
While both perform similar roles in buying and selling shares at times of maximum opportunity, there are some important distinctions that need to be made:
- Non-professional investors have more freedom when it comes to their investing patterns than institutional investors. Because they’re purely in it to expand their personal portfolios, retail investors can invest the knowledge they gain online, the trading instruments they discover and monetary information they pick up in the most effective ways they can find.
This means that retail investors can take more risks in picking out undervalued stocks that institutional investors may find too risky to touch.
- Retail investors are characterised by investing smaller amounts of money than their institutional counterparts. For instance, on popular retail investing app, Robinhood, the average account size is $3,500, while it’s not uncommon for hedge funds to make multi-million-pound investments.
- An institutional investor is an entity like mutual funds or an insurance company, meaning that they generally exist to protect the portfolios of clients on a far larger scale. However, a retail investor is simply an individual user who interacts with trading on a more casual scale.
Institutional investors have far greater financial power in affecting the stock market, but retail investors have shown that they’re very capable of mobilising to drive mind-boggling levels of price action.
(Image: Motley Fool)
As we can see from the chart above, retail investors collaborated across 2021 to generate squeezes on stocks offering little in the way of fundamentals. Companies that are rich in nostalgia like video games store GameStop and US cinema firm AMC experienced wild price rallies when forums like r/WallStreetBets generated enough market sentiment to cause a tidal wave of stock buys.
Typically these price movements could only be driven by the financial power of hedge funds and affluent institutional investors, but 2021 has been the year that’s shown retail investors have the power to significantly impact Wall Street, too.
(Image: Financial Times)
Although retail investors are capable of seismic price movements, the chart above also shows us that retail sentiment can be largely unfocused too.
As the pandemic led to more governments releasing stimulus packages that were partly invested into stocks and shares, we can see a dramatic increase in volatility throughout 2020. Whilst volatile stocks can present a great investment opportunity, the unpredictability can also be bad news for investors.
Interestingly, we can see that retail investing behaviour altered fairly dramatically during the age of coronavirus. Whilst we saw mass investment in ETFs at the beginning of the year, as we were faced with the prospect of a deep recession, interests turned to growth stocks.
As more younger retail investors received stimulus packages in the midst of lockdowns, their newfound inflows appeared to be largely invested in ESG and sustainable stocks – reflecting a wider trend of more eco-friendly actions in terms of investing and beyond.
It wasn’t until late 2020 and early 2021 that the WallStreetBets-inspired meme investing frenzy began to take off, with investors looking to bet on riskier stocks in unison to cause a huge squeeze and to make an unnaturally swift windfall for themselves.
The Pros of Being a Retail Investor
Although retail investors may not be capable of making a splash in the market in the same way that the more resourceful institutional investors can, there are still plenty of perks that come with a life in retail investing:
1. Better positioned to HODL
To adopt a term that’s become prominent across the world of Bitcoin and cryptocurrency investing, retail investors have a far greater ability to HODL (that’s hold on for dear life). The HODL means to play the long game.
Institutional investors and institutional clients will expect results on a yearly or quarterly basis, this means that they’re more likely to trade at a frequent rate and sometimes even over-trade their holdings. This can lead to higher fees that could adversely affect their portfolio performance.
Retail investors may be better able to outstay any negative short term market setbacks and corrections and to hold their assets into the long term. This allows them to use the level of patience that isn’t possible for their short-term results-based institutional counterparts.
2. Investments Without Limitations
Retail investors also have the ability to trade with more freedom than, say, hedge funds. This is because they can buy shares in a company of any size and have the ability to invest in smaller companies.
This may not apply to institutional investors and institutional clients, which may be limited in the sort of investments it can consider due to having such large amounts of money to invest. This means that retail investors can often find themselves at an advantage when it comes to finding promising small firms to add to their portfolio.
3. Better Liquidity
As retail investors are only capable of buying and selling their shares at a small scale, stock prices, commodities and growth stocks are largely unaffected by their actions. The smaller quantity of stocks makes them more liquid for retail investors. However, this isn’t the case for institutional investors, who can have a greater impact on the stock prices they buy and sell, can carry a more negative impact on assets – leading to lower levels of market sentiment and panic selling.
4. Freedom to Focus
Many institutional investors are required to diversify their portfolios as a mandatory consideration. Retail investors, on the other hand, are free to invest in whatever they like. This means that they can focus on certain aspects of investing, educate themselves on the best prospects and put their faith in them.
5. Invest in What They Love
As retail investors are individuals who are investing their own money, they’re completely free to buy into the stocks and shares that they’re interested in on a more personal level. This, however, is a luxury that institutional and professional investors don’t have – due to the fact that they’re managing the funds of an external client or entity and can’t afford to let personal interests cloud their judgement.
However, retail investors are free to follow their hearts and invest in what they like. This means that they can buy into more ESG and sustainable stocks if they’re interested only in eco-friendly firms, or they can purchase shares in their favourite tech company.
The Cons of Retail Investment
There’s undoubtedly a range of perks associated with being a retail investor when the only portfolio you’re working with is your own. However, there are some distinct disadvantages where retail investors fail to measure up to their institutional counterparts:
1. Lack of Buying Power
Sadly, it’s impossible for a retail investor to match the buying power of hedge funds or mutual funds when going it alone. The stock market is far more receptive to investors with a lot of money and tends to reward large scale investments with lower commissions on trades.
For example, if you were to buy exactly the same stock at exactly the same price, your higher commissions could eat into your profits.
This same system exists when companies decide to go public through IPOs (initial public offerings), where institutional investors typically have first refusal on 90% of issued shares.
2. Less Industry Knowhow
Retail investors typically build their portfolios as an aside from their day to day jobs. When you’re having to balance your investing strategies with everyday life, it’s inevitable that you’ll lack the same levels of expertise that institutional investors have gained over years of trading professionally.
Furthermore, big investors can afford to pay for research, and firms can even recruit in-house staff to do it full time. This means that institutional investors will invariably be more knowledgeable and agile than retail investors, who are buying and selling their investments as a hobby in many cases.
3. Fewer Industry Connections
Hedge fund managers can often get in touch with CEOs and CFOs on a one-to-one basis, or attend small group briefing sessions to build connections and get the inside track on whether companies are heading. Even if executives don’t give away their trade secrets, this insider knowledge can help to give institutional investors an edge that’s impossible for their retail counterparts to compete with.
To a larger extent, this money, connections and power can also help big investors to gain an advantage in lobbying stock market regulators. When new laws and regulations are debated on a governmental level, retail investors rarely have a voice.
4. Falling Victim to Market Manipulation
The reason why the GameStop short squeeze was hailed as a landmark event was because many retail investors believed the move gave hedge funds a taste of their own medicine in manipulating the market through coordinated buying.
There are many ways in which unethical players can take advantage of retail investors. When insider trading happens, it’s often the larger investors that hear the industry secrets exclusively. Analysts at an investment bank may advise worthless stocks to benefit the bank’s brokers, who stand to collect fees when a retail investor buys the shares. Despite information online being much more accessible, it can be hard for individual investors to compete in an unlevel playing field.
Analysing The Type of Stocks That Retail Loves
Perhaps the biggest distinction between retail and institutional investors can be found in the types of stocks they look for respectively.
Tellingly, Nasdaq analysis has found that retail investors appear to love microcap stocks, demonstrating that they’re happy to accept the unpredictability of penny stocks due to their far greater levels of growth potential.
The chart above shows us how much retail investors favour microcap stocks ahead of their larger market cap counterparts. Each circle represents a stock, with larger circles showing the higher average daily volume. Likewise, the darker circles are the more trading that occurs both off the exchange and in the non-ATS TRF (non-alternative trading system trade reporting facility). This means that the darker the dot, the more likely it is to relate to retail.
The chart also shows that the spreads in these stocks are the widest in the market, indicating a degree of risk aversion that isn’t as present in the more larger-cap institutional investments.
Data also suggests that retail investors are more prone to buy the stocks that they know. Ticker-level analysis can show that FAANG stocks tend to have an above-average market share compared to their lesser-known fellow tickers with similar fundamentals. FAANG stocks is an acronym referring to the five prominent US technology companies in Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX) and Alphabet (GOOG).
Capitalising on Opportunities in Retail
The vast majority of people who turn their hand to the stock market will fall into the category of being a retail investor, and it’s a label that should be greeted as a big opportunity for individuals to grow their wealth in a manner that may not have been possible just a decade ago.
Inflation can lower the value of money gradually over time, meaning that money kept in bank accounts can actually depreciate over the years. Stock market investments, on the other hand, generally increase over the long term, even if there may be some market turbulence along the way.
Fundamentally, the rise of cheap investment platforms like Robinhood in the US and the likes of Freetrade and Trading 212 in the UK means that individuals have an excellent opportunity to safeguard their money for the future. Although many retail investors of today are looking to small-cap options in the hope that they’ll become rich quicker, time and experience are likely to mould them into nest egg savers who can better secure their future against whatever may be lurking around the corner next.
Although the retail investment landscape is becoming increasingly populated by a chaotic generation of new kids on the block, they have a great chance to secure their wealth over the long term, and that can only be a benefit to society.