The question of whether retail investors can outperform the market has been supposedly definitively answered by the collection of individuals referred to as the finance community. Their answer is, unsurprisingly, no.
Advisers say you need their help, you can’t generate alpha on your own. Professional investors reach similar conclusions. Passive investment fans claim that consistent outperformance is impossible, hence their passive approach. Academics, too, echo these sentiments.
What do all these people have in common? Incentives to come to this conclusion. Professionals want your money, naturally. Academics/journalists want to write controversial things. Claiming active investing generally doesn’t work is/was controversial and thus generates clicks/acclaim/citations/tenure/etc. When incentives are involved, information gets distorted.
There is no logical reason to conclude that retail investors cannot beat the market. There are arguments for both sides. These investors are competing with professionals. Although many of these upstanding citizens do stupid things sometimes, they at least have some type of non-beginner knowledge of investing. Many, in fact, have lots of knowledge.
Why does this matter? The market is a price-discovery mechanism and every transaction has a winner and a loser because one party bought/sold under/over the “true value” of the asset and the other party did the opposite. Therefore, retail investors are in direct competition with professionals, who are responsible for most of the volume. You are competing with people who do this for a living. A large proportion of the smartest people in the world aren’t trying to solve climate change or cure cancer, they’re trying to beat you. And they’re working 12 hours a day, using the best technology and have access to more information.
However, these investors, unfortunately for them, have clients. This means that they are significantly constrained in what they can invest in, when they can buy/sell, and how much. They are incentivised, those incentives again, to increase AUM as much as possible, not necessarily to generate the highest alpha possible. Retail investors are agile. Professionals have the turning circle of a double-decker bus.
If only there was some way to check whether assertions were true or not. Fortunately for us, there is. Data, although often incorrectly used and/or relied upon, can usually give us a good indication of the veracity of our thinking. However, in this instance, it seems that no one has bothered to check the numbers (properly). I searched and searched to no avail (1).
I did find a recent paper on the behaviour of investors on Robinhood, which didn’t exactly paint a pretty picture (2). Some similar platforms also have to disclose the risks of more complex financial products, which can give us a hint of retail performance. Due to MiFID-II regulation, spread bet/CFD providers have to disclose what proportion of their clients lose. IG, for example, state that 75% of retail investors lose money when trading these products. Plus500 quote a similar number (3).
Interactive Investor are developing a “Private Investor Index” which measures the performance of investors on its platform. The results of their analysis for 2020 were intriguing. For starters, the median user performed significantly better than UK shares – they were up 1.8% compared to the FTSE 100 being down 11.5% and the FTSE All Share being down 9.82%. And it’s not just international passive exposure that seems to be driving the out-performance: active retail investors (4) grew their portfolios by a lofty 6.3%.
They also included some amusing demographical deconstructions. Turns out 18-24 year-olds, a bracket I am sadly no longer a part of, are killing it. I guess TikTok financial gurus know their shit. Boomers, without the ability to access this collection of high-quality information, are getting crushed. It’s actually remarkable how consistent the drop in performance is as age increases. One can only wonder what returns your annoying 8-year-old nephew could generate (5).
Put your hand up if you know what I’m going to caveat this data with. Yes, you in the back – “Is it the fact that this data only comes from one year of trading activity Haydn?” – good point, but no, someone else? – “I know, it’s the fact that this year has been atypical from a retail perspective.” – shit, I didn’t think of that. Not what I was getting at – “Incentives, Sir?” – voila. In what seems to be the theme of today, think about what the incentives of Interactive Investor are before accepting their conclusions.
They obviously want people to 1. Sign up for their platform and 2. Trade lots (6). Data can be massaged to sell anything one is trying to flog. Why did they use median investor instead of mean? Why did they compare to UK shares rather than international shares? Why did they define active investors as they did? It’s a little naive to believe that these decisions were arbitrary (7).
Academia flops (again)
There is no comprehensive academic work on the performance of active retail investors. Most studies compare the returns of investing in actively-managed funds to relevant indices, mostly concluding that active management largely isn’t good. So far, so good. The problem arises when people attempt to generalise this result to retail investors. As we have already discussed, professional active management and retail active management are different, but similar, sports, for a variety of reasons. It’s like claiming those who can’t jump are bad at basketball so they will be bad at netball too because both games are about shooting a ball into a hoop. Wrong.
Academics have absolutely no reason to research the performance of retail investors, aside from the fact that their good friend Haydn wants them to. Think about who a conclusion that active retail investors perform well would benefit. Aside from trading platforms, I am struggling (8). Putting my tin foil hat on quickly, I could easily envision a world in which this research has been done but the commissioning bodies (advisers/asset managers/retail haters) didn’t like the results, so buried it.
Question the question
Asking the right question is more important than getting the right answer.
- Do active retail investors outperform the index? This is an imprecise, unproductive question. Next, please.
- Can active retail investors outperform the index? Undoubtedly, yes. Only an idiot (9) would disagree.
- Can active retail investors out-perform the index due to skill? Probably, yes. Almost certainly yes, in fact. There must be some talented mother-fuckers out there who can crush the FTSE 100 returns.
- Does a time/effort investment significantly increase the probability of out-performance? Ooof, good question. No question it does but is the difference significant? Maybe not. Depends what you mean by significant, I guess.
- Do active retail investors outperform the index on average? Unclear but I would say probably not.
- Can active retail investors consistently out-perform the index? Unclear. For most people probably not, I would imagine.
- Does the average active retail investor out-perform the average passive retail investor? Better comparison. Answer completely unclear.
- Assuming that one can improve significantly by committing time/effort, is this time/effort commitment worth it in terms of increased return? Vital, neglected question. Again, in most cases, I would imagine the answer is no.
Like most of the posts on this site, there doesn’t seem to be much that can point to arrive at a definitive conclusion. This area needs more investigation but, sadly, I can’t see this happening anytime soon.
Active retail investing has exploded in popularity off the back of general boredom and some get-rich-quick events. People are pumping money into platforms like Trading 212, and making money doing so. Maybe the next decade will be the decade of the retail investor. Or maybe people are riding a bull market and will be left without a chair when the music stops, falling on their respective arses.
It is claimed that TikTok, WallStreetBets, and Robinhood are getting people excited about investing, which is a good thing. I’m not so sure. There may be a point of knowledge acquisition where each additional piece of information actually harms you. It’s not just standard diminishing returns, it’s actually actively harmful. I also question how useful people learning about complex financial products is to their pension investments or their personal finance structure. It’s like saying people are getting excited about health is a good thing. Yes, learning the basics is good. However, if people focus on learning how to do heart surgery rather than fundamental nutrition, it might not be so beneficial after all.
There is also something depressing about the collective time, money and energy that is currently being channelled into the financial markets, largely as a result of quarantine boredom. People could be getting their chess.com rating to above 2000, losing 5kg, reading about the lesser spotted woodpecker, developing an actually edible cooking portfolio, etc. For many, the financial markets and the rewards that they bring are too tempting a prospect. Money won is a lot sweeter than money earned.
(1) I got so desperate in fact that I was forced to ask Reddit for help.
(2) This was only over a very short time horizon and measuring a particularly idiotic/risk-hungry/bored subset of retail investors.
(3) This proportion can be misleading, we would really need to see the distribution. Those who do win might win big (or not).
(4) Those who trade at least twice a month.
(5) They also break the data down in several other ways. For example, by location of an investor. In England, it seems, the further you move away from London the lower your returns. Other parts of the UK out-perform London and the rest of England.
(6) They get commissions from executing trades.
(7) Sadly, most information is delivered with some kind of purpose, some kind of underlying sales pitch. The act of sharing information just because it’s interesting/funny/weird isn’t really a thing anymore. Even peer-to-peer networks have some kind of rewards in the form of points/upvotes/likes. When most people send something to a Whatsapp group, they are looking for some kind of reaction, not just trying to benefit the other members of the group. Sad.
(8) These platforms seem to be going down the gamification route, anyway. They are pitching active investing as a fun hobby, not as a way to generate wealth.
(9) Or maybe a journalist, who would disagree to get their story printed (to all those reading this in 2030, physical newspapers still exist at this point in time).