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Who's the smart money? You are

Created:

17 September 2007

Written by:

Chris Dillow

The losses many fund managers have suffered on complex debt derivatives suggests that professional investors might not be as clever as they pretend. This raises the question: could it be that the smart money is not the institutional fund manager but rather the ordinary retail investor? There's increasing evidence from around the world that the answer might be: yes.

Granit San, an economist at the Hebrew University of Jerusalem, has studied institutions' dealings in all stocks on the New York Stock Exchange and Nasdaq between 1981 and 2004. She's concluded that "institutions buy high and sell low, whereas individuals are the ones who buy low and sell high".

The one-fifth of Nasdaq stocks that institutions bought most heavily in any quarter underperformed the one-fifth they sold most heavily by an average of 10 per cent in the following two years, controlling for obvious market risks. As it's retail investors who are on the opposite side of these trades, this suggests that the stocks individuals buy from institutions outperform the ones they sell.

What's more, says Dr San, individuals' edge over institutions seems to be rising over time. Although it was negligible in the 1980s, in the 1993-2004, period the quintile of Nasdaq stocks that institutions sold most heavily to individuals outperformed the quintile they bought most heavily by an average of 36 per cent in the following two years.

This, though, is not the only evidence for the superiority of retail investors. A group of US researchers has estimated (pdf) that between 2000 and 2003, the 10 per cent of stocks on the New York Stock Exchange most actively bought by individuals outperformed the 10 per cent most sold by an average of 1.1 per cent in the following month.

And they found that shares' volatility tends to rise before individuals buy, but fall thereafter. This suggests retail investors dampen volatility rather than add to it. As it's generally thought that noise traders - ill-informed punters - contribute to stock market volatility - this implies that retail investors are not noise traders.

Evidence for the superiority of retail investors isn't confined to the US, however. Researchers at the Norwegian School of Management in Oslo have found evidence that some retail investors can persistently beat the market. Investors who had outperformed over a two- to five-year period were highly likely to continue to outperform in the following three years. This contrasts to institutional investors, where past good returns don't seem to lead to future good performance. This matters, because persistent performance is evidence of genuine skill: skilful performers can repeat their tricks, lucky ones can't.

Yet more evidence comes from Australia. Julia and Thomas Henker, of the University of New South Wales, looked at individuals' and institutions' behaviour during bubbles in individual share prices. They found that retail investors were less likely than institutions to be swept away by bubble fever, as they were more likely to sell into rising markets. "There is no evidence that individual investors are the marginal investors whose trading pushes prices to irrational levels," they conclude.

Granted, the evidence isn't overwhelming. This is because it's prodigiously hard to get representative data on individuals' performance - asking people about their investment performance is as likely to yield reliable information as asking men how many women they've slept with. And some evidence points in the opposite direction. Researchers at the University of California at Davis have found that the stocks bought by individuals underperform those sold in the following 12 months - although they do outperform in the following month.

Even so, all this raises a possibility. Perhaps it is retail investors who are the smart money. They are not the ones who add to market volatility by buying high and selling low. And they are not the cashpoint machine for the professionals.

There are (at least) five reasons for this:

1. Retail investors, more than professional ones, are prone to the "disposition effect". They are overly keen to realise profits, so they tend to sell winning stocks too soon. This means, in effect, that they supply liquidity to institutions in rising markets - a function for which, says Duke University's Ron Kaniel, they should (and do) get compensation in the form of better returns.

2. Institutional investors, more than retail ones, are momentum investors. They are more likely to buy stocks that have risen a lot recently. This might be because they want to window-dress their portfolios, or just stick close to their benchmarks - underperforming one's peers is dangerous for a professional fund manager, but not for a retail investor.

As a result, institutions are more likely than retail investors to buy overpriced stocks. Of course, this isn't a problem insofar as momentum investing pays off. But, the trouble is, says Dr San, that institutions are bad momentum investors who mistime their buying.

3. A good professional investor finds it harder than a good private one to continue outperforming. As his reputation grows, he attracts more money to his fund, which means he'll find it harder to buy smaller less liquid stocks without seeing prices move against him. A retail investor doesn't suffer such diseconomies of scale. So good performance is more likely to be repeated.

4. Professional fund managers might be more prone to overconfidence as a result of the illusion of knowledge. Because they spend their lives gathering information about companies, they are prone to believe that such information can predict returns when, in fact, it sometimes, or perhaps often, can't. The upshot is that they trade when they shouldn't - and heavy trading is bad (pdf) for returns. As retail investors know less, they should be less prone, on average, to overconfidence.

5. Fund managers feel moral pressure to do things. Some feel they have to trade to justify their high pay, when, in fact, they would serve their clients better by doing less. Retail investors, by contrast, feel no such pressure to be active. And, often, doing nothing is the best investment strategy.

Whatever the reason, the evidence is growing that retail investors - on average - might be able to systematically beat the professionals. The paradox is, however, that if they start to believe this, they might become overconfident with the result that their performance would suffer. So perhaps some things can only be true if you don't believe them.