Retail Investors: Definition, Impact & Challenges (2024)

What is a Retail Investor?

Retail investors are individual investors who invest their own personal funds in financial markets, such as the stock market, rather than investing on behalf of an organization or institution. They use their own savings or disposable income to buy and sell financial assets, such as stocks, bonds, mutual funds, ETFs, real estate, and other securities.

Retail investors access financial markets through brokerage accounts, either through traditional brokers or online platforms. They make investment decisions independently or with the assistance of financial advisors and typically have smaller investment portfolios compared to institutional investors.

Retail investors can have diverse investment objectives, ranging from long-term wealth accumulation and retirement planning to generating income or funding specific financial goals.

Retail investors are distinct from institutional investors, who manage large pools of money on behalf of organizations or groups of individuals, such as pension funds, mutual funds, and insurance companies.

Retail investors have several distinguishing features:

Investing for Personal Gain: Retail investors invest their own money to achieve personal financial goals, such as saving for retirement, funding education, or building wealth. They are not managing funds on behalf of others but are making investment decisions for themselves.

Limited Financial Resources: Retail investors generally have limited financial resources compared to institutional investors. They typically invest smaller amounts of money, making their investments more individually tailored to their financial situation and goals.

Direct Involvement: Retail investors have direct control over their investment decisions. They choose the assets they want to invest in, manage their portfolios, and make buy or sell decisions independently or with the assistance of financial advisors.

Less Access to Information: While retail investors have access to financial information and research, they may not have the same level of resources, research capabilities, or access to exclusive market data as institutional investors. They usually rely on sources such as financial news, investment websites, and sometimes advice from financial advisors.

Access through Brokers: Retail investors access financial markets through brokerage accounts, either online or through traditional brokers.

Compared to institutional investors, retail investors face fewer regulatory and compliance obligations because they are investing their own personal funds.

Role of Retail Investors in Financial Market

Each retail investor, as an individual, typically contributes a relatively small amount of capital to the financial markets. On its own, this contribution might not appear significant when compared to the enormous sums managed by institutional investors, such as mutual funds, pension funds, or hedge funds. However, when we consider the collective impact of their actions, their influence on the markets is quite significant.

Retail investors participate in the stock market with different goals, which may vary from one investor to another. It may include:

Wealth Accumulation: Many retail investors aim to build wealth over the long term. They invest in assets like stocks, bonds, and real estate with the goal of increasing the value of their investments and achieving financial security.

Retirement Planning: Retirement planning is a primary aim for many retail investors. They invest with the objective of creating a nest egg that will provide for a comfortable retirement, which may include investments in retirement accounts like 401(k)s and IRAs and balanced mutual funds.

Income Generation: Some retail investors seek to generate a steady stream of income from their investments. They often invest in dividend-paying stocks, bonds, or real estate investment trusts (REITs) to receive regular income payments.

Achieving Specific Financial Goals: Retail investors may have specific financial objectives, such as saving for a down payment on a home, funding their children’s education, starting a business, or paying off debt. They invest with these goals in mind and often opt for instruments such as index funds or high-yield savings accounts.

Capital Preservation: For those concerned about preserving their capital, the primary goal is to protect their investments from significant losses. They often opt for lower-risk, more stable assets such as bonds or treasury bills to achieve this goal.

Speculation: Some retail investors engage in speculative trading, aiming to profit from short-term market movements. Their goal is to capitalize on price fluctuations and make quick gains. They often opt for derivatives like options and cryptocurrencies.

Retail investors participate in financial markets, including stock market, keeping such goals in mind. But other than these personal benefits or goals, what do they bring to the market? Much more, I would say. Retail investors are an important component of the stock market and the broader financial system. Their participation contributes to market efficiency and overall economic growth. Many retail investors have a long-term perspective when investing in stocks. This approach can add stability to the market by countering short-term speculative trading activities, contributing to a more balanced and less volatile marketplace.

Liquidity Providers: Retail investors provide liquidity to the market by buying and selling stocks and other securities. Their trading activities help maintain orderly markets and ensure that there are buyers for sellers and vice versa.

Price Discovery: Retail investors enhance price discovery by expressing their views on the value of assets. Through their buy and sell orders, they actively contribute to establishing market prices for securities.

Capital Formation: When retail investors purchase shares of companies through initial public offerings (IPOs) or secondary offerings, they contribute to capital formation. This capital allows companies to fund their growth and expansion.

Wealthier retail investors who qualify as accredited investors also have access to alternative investment classes like private equity, venture capital, and hedge funds. Accredited investors are individuals or entities that meet specific financial criteria, as defined by securities regulations in many countries, including the United States. These criteria include having a high net worth or a significant annual income.

Retail Investor vs Institutional Investor

Based on the scale of investment, level of expertise, and the purpose of their investments, investors are primarily classified into two categories: retail investors and institutional investors. As discussed above, retail investors are individual investors who trade or invest in financial markets using their personal funds and are not investing on behalf of an organization or institution.

On the other hand, institutional investors are large organizations or entities, such as mutual funds, pension funds, insurance companies, hedge funds, and investment banks that invest substantial amounts of money on behalf of their clients or shareholders.

Unlike retail investors, institutional investors manage large pools of capital, often in the millions or billions of dollars. Professional fund managers and experts make investment decisions on behalf of institutional investors, following specific strategies. They have defined risk profiles and investment guidelines tailored to their specific mandates and the preferences of their clients or beneficiaries.

What Percentage of Stock Market is Retail Investors?

The percentage of retail investors in the stock market can vary over time and across different markets. It is influenced by factors such as market conditions, economic trends, and investor sentiment. However, their share of the total market capitalization or trading volume may be smaller compared to institutional investors, who often trade in larger assets, in huge volumes, and more frequently.

In recent times, an increasing number of individuals are venturing into stock market investments. A 2023 Statista report states, “In 2023, 61 percent of adults in the United States invested in the stock market. This figure has remained steady over the last few years, and is still below the levels before the Great Recession, when it peaked in 2007 at 65 percent.”

However when you consider the percentage of retail investors in terms of market capitalization, they are much less when compared to institutional investors. In the United States, for example, retail investors typically own around 10-20% of the total market capitalization.

However, when you consider the indirect investments of retail investors made through mutual funds and pension funds, this figure goes much higher. A 2020 Nasdaq report states, “Retail investors own 77% of the market capitalization in total via stocks (held directly), mutual and pension funds. Some would even argue that all three categories are retail assets, it’s just that funds are bundled and also managed by professional investors.”

Nevertheless, the share of retail investors based on trading volume is considerably lesser. According to a 2021 Bloomberg report, “The retail trading surge that began with pandemic lockdowns has now abated, as total equity volume from individual investors fell to 19% in the third quarter, down from 24% at the start of this year, according to Securities and Exchange Commission and market data compiled by Bloomberg Intelligence.”

Impact of Retail Investors in Stock Market

Though the percentage of retail investors is comparatively less in terms of both market capitalization and trading volume, do not downplay their impact. Not yet. Because collectively they do have the power to influence the stock market.

To illustrate, let me provide you with an example. Many of you might have heard about a meme stock.

A meme stock is a term used to describe a stock that experiences a sudden and often dramatic surge in popularity, trading volume, and price due to social media, internet forums, and online communities, rather than traditional financial metrics or fundamentals. These stocks are propelled by the collective actions and sentiments of retail investors who gather on platforms like Reddit, Twitter, and other online forums to discuss and promote specific stocks.

Retail investors impact the markets in following ways:

Market Sentiment: Retail investors’ collective behavior can impact market sentiment. Their decisions can lead to bullish or bearish trends, affecting the overall mood of the market.

Liquidity Enhancement: Retail investors help maintain liquidity in the stock market. Their participation ensures that there are ample buyers and sellers in the market.

Market Stability: The longer-term investment approach of many retail investors contrasts with the short-term speculation of some institutional traders. This stability can help mitigate market volatility and promote a more stable market environment.

Economic Confidence Indicator: The level of participation of retail investors often reflects their confidence in the broader economy and financial system. Their collective actions can serve as a crucial indicator of overall economic health.

Do Retail Investors make Money?

Retail investors have the potential to make money in the stock market. However, their success depends on various factors, including their investment knowledge, strategies, risk tolerance, and market conditions.

But do they actually make money? According to various reports, on an annual basis, most retail investors do lose money in the stock market. An article by OnlineDasher states that “69% to 84% of retail investors experience losses” in the U.S. stock market.

When it comes to trading, and in particular day trading, these figures are even more abysmal. A study done by Philadelphia Financial (a hedge fund) found this interesting data about Retail Foreign exchange trading (retail FX) – “approximately 70% of customers lose money every quarter and on average 100% of a retail customer’s investment is lost in less than 12 months.”

When it comes to trading, especially day trading, these figures are even more abysmal. A study by Philadelphia Financial, a hedge fund, revealed interesting data about Retail Foreign Exchange trading (retail FX): “approximately 70% of customers lose money every quarter and on average 100% of a retail customer’s investment is lost in less than 12 months.”

It’s important to note that the stock market can be volatile, and there are no guarantees of making money. Some investors may experience losses, particularly during market downturns. The key is to have a well-thought-out investment strategy and the discipline to stick to it. Over the long term, many retail investors have seen their investments grow, benefiting from the historical upward trajectory of stock markets.

Why Retail investors are called dumb money?

“Dumb money” and “smart money” are terms used in the financial and investment industry to describe different types of investors or traders based on their behavior and decision-making qualities and strategies.

The term dumb money is often used to describe retail investors and traders. It implies that retail investors are perceived as less informed, less sophisticated, or prone to making irrational or uninformed investment decisions compared to institutional investors or smart money.

Various reasons contribute to labeling retail investors as dumb money. They often make investment decisions based on emotions rather than a rational assessment of fundamentals. Fear, greed, and panic can influence their choices, leading to suboptimal outcomes. Retail investors are more likely to follow investment trends, market fads, or stock tips from social media, friends, or news headlines. They may buy assets when prices are at their peak due to the fear of missing out (FOMO).

On the other hand, smart money typically refers to institutional investors, including hedge funds, mutual funds, pension funds, and professional traders. These investors often possess significant resources, expertise, and access to advanced market analysis tools.

Dumb money investors may not conduct thorough research on the companies or assets they invest in. They might not fully understand the financials, market dynamics, or the long-term prospects of their investments. In contrast, smart money investors employ sophisticated investment strategies, which may include fundamental analysis, technical analysis, quantitative modeling, and risk management. They make data-driven decisions.

Dumb money investors often neglect proper risk management techniques, while risk management is a priority for smart money investors. The latter use stop-loss orders, diversification, and position sizing to limit potential losses and protect their capital.

It’s important to note that this distinction between dumb money and smart money is based on broad behavioral patterns and is somewhat pejorative. Not all retail investors make poor choices, and not all institutional investors make smart decisions.

Successful investing requires a well-thought-out approach, whether you are an individual investor or an institution, and it’s essential to continuously educate oneself and adapt to changing market conditions.

Challenges Faced by Retail Investors

Retail investors face various challenges when participating in the stock market and other investment avenues. Some of the common challenges they encounter include:

Limited Knowledge: Many retail investors lack comprehensive knowledge of financial markets, investment instruments, and investment strategies. They might not fully understand the risks and rewards associated with different investments.

Emotional Decision-Making: Retail investors are susceptible to emotional decision-making. Emotions like fear, greed, overconfidence, and panic can lead to impulsive and irrational investment choices. Emotional trading often results in buying high and selling low, which can erode returns.

Lack of Research: Retail investors might not conduct thorough research before making investment decisions. This can lead to investing in companies or assets without a clear understanding of their fundamentals and prospects.

Inadequate Diversification: Some retail investors put too much of their money into a single investment or a small number of assets. Lack of diversification can increase risk because a poor-performing asset can significantly impact the overall portfolio.

Market Volatility: Retail investors may struggle to navigate the inherent volatility in financial markets. Sudden price fluctuations can trigger panic selling or buying, leading to losses.

Access to Information: Retail investors may not have the same level of access to real-time market information, research reports, or advanced trading tools as institutional investors.

Limited Resources: Retail investors often have limited financial resources compared to institutional investors. This can restrict their ability to invest in certain assets or take advantage of opportunities.

Time Constraints: Balancing a job, family, and other responsibilities can limit the time retail investors can dedicate to research, monitoring, and managing their investments.

Lack of Discipline: Discipline is crucial in investing, but retail investors may deviate from their established strategies or trading plans due to emotional reactions.

Psychological Stress: The emotional toll of investing, especially during market downturns, can lead to psychological stress and anxiety.

Lack of Risk Management: Retail investors may not implement adequate risk management strategies, such as setting stop-loss orders or having an exit plan for their investments.

Lack of Patience: Retail investors may not have the patience to hold onto investments for the long term, often seeking quick profits.

Overtrading: Some retail investors engage in excessive trading, driven by the need for constant action. Overtrading can lead to high transaction costs and reduced returns.

Psychological Challenges

Retail investors also often encounter various psychological biases that can significantly impact their decision-making and investment outcomes. Some of these challenges include:

Loss Aversion: Retail investors tend to feel the pain of losses more acutely than the pleasure of gains. This loss aversion bias can lead to a reluctance to sell losing positions, even when it might be the rational choice.

Overconfidence: Some retail investors overestimate their knowledge and abilities, leading to excessive trading and taking on more risk than they can handle. Overconfidence can result in losses when investors make speculative bets.

Anchoring Bias: Retail investors may anchor their investment decisions to past prices or information, even when those factors are no longer relevant. This can lead to buying high and selling low.

Confirmation Bias: Investors often seek information that confirms their existing beliefs or investment decisions. They may disregard or downplay information that contradicts their views, leading to potential losses.

Herd Mentality: Retail investors sometimes follow the crowd, investing in popular stocks or trends without conducting their own research. Herd behavior can result in asset bubbles and subsequent crashes.

Regret Aversion: Investors may avoid making decisions to prevent future regret. This can lead to inaction and missed opportunities.

To address these psychological challenges, retail investors can:

• Educate themselves about common biases and cognitive errors.
• Develop a well-thought-out investment plan and stick to it.
• Practice patience and maintain a long-term perspective.
• Avoid making impulsive decisions.
• Diversify their portfolios to manage risk.
• Use risk management tools like stop-loss orders to limit potential losses.

By being aware of these psychological biases and taking steps to mitigate their impact, retail investors can make more rational and informed investment choices.