Paper & Blocks

Retail or institutional, every market participant is unique.

Renaissance Technologies is comprised of a cocktail of capabilities, expertise, and patient capital that others simply cannot match. Those characteristics are very different from a Millennial retail investor who stays active on investment forums, an insurance company that has to match assets to its liabilities, or a retiree whose primary objective is to generate income.

Most of these differences boil down to two things: strategy and circumstance.

• Strategy is the approach you take to the market: What type of investment risk are you willing to bear? Are you fine with the index, do you focus on factors, are you hunting for arbitrage? 
• Circumstances are the constraints you work within to execute your approach: How patient is your capital, how unique are your capabilities, what markets do you have access to?

Most assume institutions have an advantage over retail investors in terms of both strategy and circumstance… and that is mostly true. After all, the markets are a competition.

A theme running through the Invest Like the Best podcast is ‘this is who you’re up against’ illustrating the impressive capital allocators that inhabit the industry. Institutions have more scale, structure, capabilities and expertise to focus on the same set of market opportunities that retail investors have access to.

Pit an ‘Average Joe’ day trader up against an army of investment professionals and it is clear who should come out on top.

But it is not just the factors above that put a wind at the institutions’ backs. For most retail investors, their biggest impediment is most likely themselves. Here is a snippet from an old Masters in Business podcast with Jim O’Shaughnessy as the guest:

O’Shaughnessy: “Fidelity had done a study as to which accounts had done the best over time. And what they found was…”

Ritholtz [Host]: “They were dead.”

O’Shaughnessy: “…No, that’s close though! They were the accounts of people who forgot they had an account at Fidelity.”

There are numerous studies that explain why this happens. And they almost always come down to the fact that our minds work against us. Because of our behavioral biases, we often find ourselves buying high and selling low.

While much has been written about the fallibility of the retail investor, history is also full of examples that demonstrate the fallibility of professional money managers as well. These shortcomings span personal factors like the influence of career risk to structural factors like the scourge of ‘groupthink’. Those personal and structural limitations can create strategies and circumstances where retail investors have an advantage over their institutional counterparts. Yes, they are rare. But if you squint hard enough at the history of investing, some examples stand out.

1/ Retail Intuition: When Passion Creates Conviction

As highlighted by Jim O’Shaughnessy above, because of their behavioral biases, it is very difficult for retail investors to successfully buy low and sell high. Fear (specifically, FOMO) often drives the desire to ‘buy high’, despite what an analytical approach might otherwise suggest. Loss aversion is often the culprit pushing the desire to ‘sell low’, even if the investor knows it is likely a sub-optimal time to exit a position. These are examples of emotions working against the retail investor and anyone who has had ‘skin-in-the-game’ tends to know these feelings well.

There are rare circumstances where biases or emotion can actually work in an investor’s favor. This typically occurs when the emotions are not associated with the investment itself (at least in terms of dollars and cents), but rather associated with the company, brand or community around it. Some of Tesla’s (TSLA) most ardent supporters will not sell the stock, regardless of performance. They love the cars, they love the eco-friendliness of electric vehicles, they love Elon, and they especially love the social signals they can send while driving their Model 3 down the street. Their passion for the company leads to conviction in the stock, holding on to it for reasons beyond its return profile. This can help combat the loss aversion bias and prevent selling low when a volatile stock like TSLA inevitably dips.

Of course, this is only an advantage if the investment opportunity has a robust return profile… Can’t this bias also cause investors to hold on to a losing position for far too long as well? Yes! But, that is where ‘retail intuition’ comes into play. Retail investors might not have as sophisticated of an ‘investment radar’ as the institutions, but as consumers, they likely have a well-honed product radar and that is where their advantage lies.

As yoga pants migrated from the yoga studio to main street in the early 2010s, consumers were able to see and participate in the athleisure trend well before Lululemon (LULU) became a Wall Street darling.

Similarly, the lines forming outside Apple stores for the release of the iPad in 2010 (or the iPhone release that proceeded it, or the iPod release that proceeded that) were clear signals consumers were able to pick-up on that hinted that Apple (AAPL) was going to be something special.

Retail intuition is the ability for retail investors to see and hang on to profitable investment opportunities by using their consumer lens instead of their investment lens. Their passion and conviction come from something other than solely investment returns and can therefore help combat the typical behavioral biases other market participants may face.

From TSLA to LULU to AAPL, there are countless examples of opportunities that retail investors were willing to take advantage of with higher conviction than their institutional counterparts.

2/ Retail Curiosity: The Advantage of Social Signaling

Social signals are the tangible indicators of some intangible quality that increases a person’s social status or group affiliation. In other words, they are things we ‘do’ or ‘own’ that say something about who we are. This is typically done with the intention of enhancing one’s social status by either finding a way to ‘fit in’ or ‘stand out’ amongst our peers.

From an evolutionary perspective, humans are social creatures that have evolved to live in tribes where there is safety and security in numbers. To access that safety and security, we have acquired two deeply rooted desires. The first is to ‘fit in’: a way to demonstrate we are ‘one of the group’ by looking and acting like everyone else. The second is to ‘stand out’: a way to separate ourselves from others in the tribe to ensure we have unique ‘value’ and cannot be easily replaced.

While we previously relied upon our physical and/or personal traits to send signals about our ability to fit in or stand out, today, we rely more heavily upon external mechanisms like our possessions. For retail investors, these are often tangible items like the Tesla Model 3 or Apple iPad already mentioned. But, as has been written about already here, an investment portfolio can also be a signaling vehicle. This is why things like the Byzantine General’s Problem or explanations of acronyms like HODL, WAGMI, NGMI, and GM became regular Thanksgiving dinner conversation topics. Retail investors who were finding entertainment going down crypto’s various rabbit holes were eager to spread their gospel as a way to signal to their friends and family what they had been up to (a form of humble-bragging).

Curiosity is often what drives some retail investors to find the opportunities that they do and social signaling is what helps them to build their conviction. In other words, they like to show off the risks they are taking to others as a way to ‘stand out’ rather than ‘fit in’. This can drive the retail crowd into opportunities that are often out of reach of the institutional crowd (like crypto), who are subject to the opposite social signaling limitation.

If retail investors want to ‘stand out’, many institutional investors often want to ‘fit in’. Best practices dictate that asset managers use an appropriate benchmark (often an index) to judge their performance. Underperforming that index for a sustained period can collapse a career. After all, an asset manager’s track record is their best marketing asset, so there is an incentive not to deviate too far from the norm.

Career risk is one of the biggest enemies of alpha and overcoming the often unconscious desire to play it safe can be a major obstacle to beating the market. The rise of closet indexing only serves to strengthen this point.

Investment opportunities that are outside the Overton window of the asset management world, much like crypto has been until the present day (fingers crossed for an ETF in 2024), are therefore more likely to be pursued by a retail crowd first, regardless of the attractiveness of the associated investment theses. The career risk and desire to ‘fit in’ in the institutional world is one area of advantage for retail investors who are looking to ‘stand out’.

3/ Retail Access: Dancing Around Structural Barriers

One of fintech’s most noble objectives is the democratization of finance. A directional arrow of progress in the industry is to take what was once only available to institutional investors and make it available to the masses. Everything from zero-commission and fractional share trading to automating sophisticated strategies like direct indexing has significantly lowered (or eliminated) barriers to access for the retail crowd.

While the barriers in the way of retail investors are often discussed, there is a less-discussed set of barriers that prevent institutional investors from executing on certain investment opportunities as well. Two of the big ones are ‘scale barriers’ and ‘regulatory barriers’.

Scale barriers are exactly what they sound like. Institutional investors often have restrictions on investing in smaller companies or illiquid assets due to the size of their funds. It is hard to invest in a $10 million company with a $10 billion fund, both because the investment will not materially impact the return profile of the fund, and because there likely is not enough liquidity to keep the market stable when entering and exiting the position. On the other hand, a $10 million company can certainly be material in the portfolio of a retail investor who can also take a position in a smaller size without significantly impacting the market. This leaves some white space in public microcap companies where retail investors can play while facing a lower degrees of competition from their institutional counterparts. Of course, this opportunity has not gone unnoticed and there are specific organizations like MicroCapClub that exist to execute on this thesis.

Regulatory barriers are perhaps less commonly encountered, but they exist. One example is in the U.S. cannabis space where a grey zone has been created around the legality of the drug. Cannabis remains federally illegal as a Schedule 1 substance (although, that may soon change) but has been legalized for either medical use and/or adult recreational use by some states. For federally regulated entities like U.S. banks and brokers, holding U.S. cannabis stocks is a no-go, which has forced the biggest companies in the industry to list their securities in Canada and has prevented any of the major U.S. custodians from holding the securities on behalf of customers on their platform. This has severely limited institutional investor participation in the sector with some estimates suggesting the shares of publicly traded U.S. multi-state operators are 95% held by retail investors. For comparison, the stocks that comprise the S&P 500 are 80% held by institutions. This presents an opportunity where retail investors have had a chance to effectively front-run institutional participation in an emerging sector of the market, one that has many potential catalysts for growth in the years ahead.

4/ Retail Herds: Strength in Numbers

Set an amateur retail investor head-to-head against a professional money manager and the money manager will come out on top ninety-nine times out of one hundred. But match a coordinated group of ten thousand retail investors against that same money manager, and the odds of a retail victory become much higher. This idea is epitomized by the meme stock craze of 2021 (a story told by some big name actors below):

The internet has provided the retail crowds with new ways to coordinate. Countless investment tribes are able to form every day on platforms ranging from general social media sites like Reddit to investing-specific apps like Blossom and Stocktwits.

This opportunity to coordinate efforts puts a new capability into the hands of retail investors everywhere. No longer do people have to ‘go it alone’ from the depths of their basements. Instead, they can band together and pool resources to more thoroughly research their investment opportunities, collectively advocate for a specific stock, or force the hands of others through sophisticated maneuvers like short-squeezes and gamma-squeezes.  

There Are No Guarantees

Retail investors may not be as fallible as widely perceived.

Both strategy and circumstance can work to their advantage in specific scenarios.

The examples above do not ever guarantee that David will beat Goliath. They simply indicate that the little guy perhaps deserves more credit than he has historically been given.