Retail Waves vs. Smart Money: Trends and Risks
Yannis Sardis, 19 March 2021
According to a recent survey by Deutsche Bank, US retail investors (with an online brokerage account) plan to put a significant part of any forthcoming stimulus cheques into the stock market: Respondents aged between 25 and 34 and 18 to 24 plan to spend 50% and 40%, respectively, of their relief payments on equities. Notably, 61% of those surveyed earned an annual income of up to USD 50,000, whilst 77% were new to the markets with less than 2 years of online investing experience.
Young non-professional investors tend to be more aggressive than those with more experience in the markets, with an appetite to leverage their trades by borrowing capital or using options, and with their research process being primarily driven by social media content than by fundamental, technical or quantitative analysis. And before we label this as a generational trend, note that even respondents between 35 to 54 plan to put 37% of their stimulus cheques into stocks.
Retail investors become a driving force behind the US stock market moves. Bloomberg Intelligence estimates that retail investors have on average accounted for 23% of all US equity trading in 2021, almost twice the level of 2019, thus creating a stock market footprint which is as big as all hedge funds and mutual funds combined (the so-called ‘smart money’, a term that indicates the capital placed in the market by institutional and professional investors).
Historically, uncontrollable large-scale retail inflows have been a contrarian indicator, an early-warning signal that equity markets are reaching maximum levels of overvaluation. Retail investors tend to be the first to rush for the exit when market bubbles start to pop, liquidating their portfolios at unfavourable prices and incurring massive losses.
Although, there is nothing wrong with younger and less experienced investors familiarizing themselves with the financial markets, in order to understand the intricacies of investments and profit when opportunities arise, such sustainable trends cause wild volatility fluctuations which should alert all sides of the investment acumen spectrum.
Professional money managers could dismiss the effect that the retail trading waves can have on their proprietary or client portfolios, based on the perception that the underlying investors are inexperienced, or that they will disappear at the end of the pandemic lockdown (although 59% of the survey respondents were employed full time). Alternatively, they could factor such sustainable patterns into their portfolio risk analysis, by monitoring changes in daily correlations between individual stocks, industrial sectors, thematic trends, or asset classes, and by stress-testing their portfolios for price volatility surges across various market segments.
Non-professional traders, on the other hand, could simply keep riding the recent wave, being facilitated by fees-free trading, the use of fractional shares, an easier access to borrowing, a plethora of attractive trading user interfaces and the ever-growing social media news flow. Alternatively, they (and their reference online platforms) could use available analysis tools to risk-adjust their positioning to the possibility of violent market shifts, by looking at the changing correlations between their holdings, as well as by assessing worst-case-scenarios and maximum potential portfolio drawdowns, if sudden capital outflows occurred.
We cannot predict the size and timing of the next big market downturn. We can however mitigate the main risks involved via the use of software tools to govern our decision making, thus protect us from our own behavioural biases. To avoid risk concentration and clustering, investors should utilise systems that adapt their modelling to current market conditions by assigning heavier weights to most recent observations.
All investors should embrace a systematic and adaptive investment approach, to ring fence their portfolios from downside risks whilst also participating in market upsides. Especially in times where divergence from rationality and self-interest seems to be extreme, one could maintain an ambition to profit but also preserve hard-earned capital.
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