Retail investors are on the rise. Representing 10% of trading in 2019, they accounted for over 20% of stock market volume during the Covid crisis in 2020. Since then their number started to decline, but remain on an elevated level.
So who are those retail investors? We can expect them to be people, not firms or computer-driven trading strategies, so a natural person.
A broader participation on capital gains appears to be a good thing, sadly throughout most studies we can find that retail investors show a below market performance. Consolidating some of the findings we can see the following.
- Individual investors under-perform the market.
- The higher the trading activity, the more individual investors under-perform the market.
- The higher income or education are, the higher the diversification of portfolios
- The more knowledgeable an investor thinks he is, the more he trades.
This already gives an impression of the issue. It’s similar to studies that show that 80% of drivers think they are above average drivers. I like to think we can safely apply that to retail investors, so us, as well. In extension we also seem to project that onto asset managers, assuming they must have a higher chance to make above average returns, since it is their profession.
Deviation from market returns
How does the investment world of retail investors look like? It is a place that can bring market performance. Then there is a possibility for any non-market portfolio to perform either better or worse, resulting in a deviation from market returns.
In this world we do have approximations to a market portfolio from ETFs covering global stocks. It is important to note that this is not a zero-sum game. Taking past experience we can assume there is a positive estimated value of around 7% per year, that can be considered the baseline for performance expectations.
Every rational investor would consider options to increase individual performance above the baseline. It is possible to do so and some investors have consistently shown this. Warren Buffet, a famous investor, therefore argues that diversification is for people that don’t know what they are doing.
In that logic, investment into know-how to identify better performing stocks from the ones that under-perform in the future will therefore lead to higher returns than the market. A whole industry evolved around this conviction.
Why then do retail investors consistently under-perform the market? We have seen how overconfidence gives us the impression to “know” something that will make a decision a good decision. Truth is, whatever we can know, outside of insider information, is very likely already priced into the market. The game is therefore understanding what we don’t know to eliminated bad decisions, instead of trying to make ourselves believe we could make good ones.
Whoever had the chance to see a Bloomberg terminal will have an easier time understanding retail investor limitations. This is real-time feed of information a retail investor has no access to, and even if that was the case, we have to read with our eyes and process information with our brains. A computer is better in identifying relevant information, at scale, to make a potentially superior investment.
Not a zero-sum game
But there is more and of even higher relevance. Imagine a poker table. Several players hiding their faces behind their cards, poker chips in front of them and a big pile of chips in the middle of the table that they are playing for. The game is to outsmart the other players for their money. That’s called a zero-sum game. Whenever a player wins a game, they win the same amount that the others loose.
When a pot is won (the chips in the middle) the organizer of the location, usually a casino, takes what’s called a rake. It is like a transaction cost that helps the casino run their business. Let’s assume it is 5% of big pots that are played.
So it is not 100% of the pot that is distributed between all players but only 95%. It is therefore not a net-positive game like a stock market portfolio, or a zero-sum game like a pure poker game at home. Usually the top 50% of players would make money playing the game. With the one-time rake of 5% it is now only the top 45%.
Taking two players with a pot of 50€ in the middle the casino would keep 2,50€. Now here is the trick: it’s not a one way road. The winning player will not win all the time. Sometimes you win, sometimes you loose. It is inherent to a game of uncertainty, so with elements of “luck”.
If the two players played the same pot, just the other way round, the casino takes 2,50€ of the pot again. The players would be where they started, only to realize each one of them is now short 2,50€. If they continue playing each transaction takes money out of the pool that is being played for. A winning player does not only need to be better than another. He needs to be better by a margin that he obtains the money from the other player faster than the casino can reduce the pool of money on the table.
Looking through statements of poker players and professionals, most of them estimate that only around 15% of them are making money, not meaning they make much, but that they are at least net-positive. Even that is predicated on a short- to midterm view. It is unclear for how long that would remain to be true. Anyone can statistically be “lucky” for some time, but only for so long.
The stock market has the same fundamental structure. There are people that sell a stock, others that buy it and intermediaries that earn money from the transaction.
Every buy and every sell has a direct cost. Adding to this there are more hidden costs to the game. Highlighting two of them, there’s the added cost of trying to obtain the know-how to make decisions that lead to above average portfolio performance and opportunity cost of doing so.
Direct cost of transaction
When buying a stock there are fees. Assuming they are 1% of the amount spent, they also incur when selling the stock, so again 1%, leading to a total of 2% per transaction as cost is applying to each side, buyer and seller.
Germany has Neo-brokers similar to Robinhood. They are supposedly free of charge or have a relatively lower fee. But they do have considerable spreads. The cost is conveniently hidden, but from past experience it is actually higher than regular online brokers in many cases. I often found spreads to be considerably above 1%.
They are very attractive for investors with comparably low amounts of money to invest, opening up the market for them were they would have been priced out of participation. The percentage of the invested sum the spread represents quickly finds it’s break even to favor the more fixed pricing of regular online brokers. As a rule of thumb I take roughly 500€ as the tipping point. If the sum is above that a regular offer should be considered, or at least closely checked for spreads.
While overall cost can be much higher, people still feel better with costs hidden away like that. With increasing volatility cost has a decreased perceived importance. Crypto traders have a particularly low cost sensitivity and 10% per transaction have been a real thing for some time. Transaction costs are rapidly decreasing but are still elevated compared to more mature markets.
Added cost
Commonly known costs are fees for brokerage accounts, yet there is much more. Tax reporting can induce higher cost covering capital gains. Investing through vehicles like ETFs or funds adds about 0,2–0,6% per year for regular ETFs and around 2% per year for regular funds.
Besides these sometimes unavoidable service costs, we have to consider optional retail investor costs. Let’s start with books, courses, webinars, software, apps, share letter, and many more. Consolidating them we can consider anything that makes for more convenient administration or enables know-how supposedly giving the edge to invest better. Even streaming and on-demand offers like Youtube or TicTok are paid models, although it is not paid directly but though ad sales that come with the clips.
While it seems convenient to have little helpers or trusted gurus, for retail investors most costs are way out of proportion to their portfolio size and to the impact those offers can have to the upside.
Let’s take look at a fictive retail investor: The app that shows all brokers on one consolidated overview costs only 5€ per month, that’s really nice as it also runs analysis into time-weighted average returns and individual dividend ratios. Then there is this book that will give the right mindset that is second hand for only 10€. The other is a classic that is paperback for 30€ but will look nice on the book shelf. A month ago there was this free of charge webinar and they handed out everything they’ve shown for a small cost-coverage of 7,99€. A big PDF. Then there is this news site that has really cool articles, that is just 6,99€ per month.
All in all those are quite modest expenditures. So let’s have a look what this means for a regular portfolio. For Germany numbers are hard to get, but median stock portfolio size should be around 10.000€.
Cost to get information was 12*5€+10€+30€+7,99€+12*6,99€ ~192€ per year in added cost. That is about 2% of portfolio size. Is it worth spending 2/7, so 28%, of average yearly returns to get this information? Will the information obtained enable an out-performance of 2%?
Conflict of interest
The money you pay is the money others earn. Therefore either do providers encourage more frequent transactions with tools like gamification, hedging, stop orders or a general framing suggesting sensibility of following patterns, sentiment, cutting losses, securing wins, or basically any reason to change the perspective on your holdings. When investing becomes a trading experience the capital market turns into a casino with its main purpose being entertainment.
Beyond these entertainment offers a wide grey zone begins that continues into barely legal to an extend that can be quite shocking. The folklore that people could quit their jobs and make money trading stocks, options, or much worse Contracts for Difference (CFDs), Commodities or basically anything that is high risk, high reward (for those that offer the service of course) is absurd looking at the numbers. Yet so many people engage into this idea that a whole industry lives very well of it.
Every third finance clip on youtube shows me the grey haired tigress that knows I can earn 2.134–5.672€ more per month trading, if I just watch the ad until its end. And it’s exactly those numbers, she just knows. She made it, so I can do it too. I don’t even want to go into the wannabe self-made kids with their Rolex and Ferrari. Sadly it’s not always as easy to stay away from scam.
The last cost to consider is not only peace of mind, but opportunity cost. All the time invested into investing can be interesting. The same time it can lure people into a world in which retail investors are simply not fit to compete. The same amount of time invested into progress in school or occupation, could lead to much higher revenues from offering work for a salary, or running a business.
Market efficiency
Present actors on capital markets increase efficiency in a way that spreads for arbitrage as well as valuation errors have become smaller. This has led to a situation that professional funds managers cannot reliably outperform ETF constructs anymore. They have proven to be unable to earn the 1–1,5% they charge above ETF cost to justify their own cost. Understanding that well educated professionals with access to Bloomberg terminals and a high paid talent pool of programmers cannot beat 1,5% portfolio performance tells the story why retail investors should cease fishing the same pond, trying to catch the bigger fish.
There is a way
To paraphrase on old classic: Believe that there is a way of escape for you. Temptation doesn’t become sin until you agree with it, so the way of resistance is the way of escape. Resist temptation and be an overcomer!
Other than with lottery, poker or any other game for money, there actually is a net-positive average return with stocks that results from added value through the companies. What retail investors can do is garner as much of it as possible. If any transaction, on average, is a negative contribution to performance they should be minimized, while avoiding any added cost.
Diversified ETFs seem to be the fairest possibility retail investors have. It means giving up a relatively small amount of the portfolio size for the service of diversification and market returns. If retail investors can’t beat the market, they need not concern themselves with it. Less is more. Literally.