Goliath Needs David: The Retail Investor Boom and Why it Matters for Financial Institutions

Meeting someone without a trading account is a rarity nowadays. Home-ridden people from around the world endured lockdowns by baking bread, building puzzles, and investing in capital markets, in many cases for the first time. Pre-pandemic, amateur or retail investors were perceived by institutional investors as mere gamblers; they were largely overlooked because their influence on financial markets was minimal at best. Now, retail investors have proven themselves to be a mighty force, with the power to tip the scales in their favor and skyrocket valuations. In 2021 alone, retail investing accounted for 23% of all US trading in equities, about the same percentage taken by hedge funds and mutual funds combined. These new entrants have transformed the market landscape into their playground; institutional investors and financial firms will need to incorporate these players into their equations to stay competitive and relevant. 

Not surprisingly, the entry of these amateur investors rattled financial markets; retail investing has not resurfaced since the Dot Com bubble in the 90s, and even in that case, its influence was a fraction of what it is today. Since the 1990s, the internet has grown into a full-fledged system with myriad social media platforms and forums. The infamous r/WallStreetBets Reddit forum has amassed 9.4 million members, ten times more than it had at the start of 2020. Increased connectivity among this new generation of investors has made what used to be a secluded corner of the web the cultural hotspot for financial advice. 

From a financial innovation perspective, the engineering of trading apps and online brokerages has broken the barriers to entry into financial markets. Robinhood led the way for commission-free trading; by 2020, most of its competitors had implemented trading nil fees, meaning that customers had a repertoire of choices for their virtual brokers. Before the emergence of trading apps, people would have had to contact a broker via phone or meet them in-person to execute a trade. Trades can now be executed at the top of a skyrise but also at the grocery store or from the comfort of the couch - no humans required. Several brokerage apps also have a key feature: users do not need to worry about having “enough” funds to invest because the app also offers fractions of securities for sale. If an investor wants exposure to Amazon stock without spending over $2,000, they can buy a fraction of an Amazon share for a fraction of the price.

The GameStop frenzy was the grand culmination of these factors. GameStop was the largest video game retailer in the early 2000s, but by mid-2020 its stock price was around $4 per share, and its growth prospects were looking dire. Several hedge funds shorted the stock as a bet against its performance, expediting the downward trajectory of the company. A short position involves borrowing an instrument and selling it again on the market, with the intent of buying it back at a lower price to return it to its original owner and make a profit. Redditors saw an opportunity to hit back at these hedge funds: by inflating the price of GameStop, they would cause the short sellers to buy back the stock at a higher price, incurring a loss. The Gamestop defenders thus encouraged forum-goers to buy GameStop shares to create demand and increase the price. The ensuing appreciation of the GameStop stock, reaching a peak of $483 intra-value in late January 2021, resulted in GameStop short sellers incurring an aggregate mark-to-market loss of $6 billion. 

So, what does this all mean? That in a seeming David-and-Goliath faceoff, the underdogs triumphed over the corporate giants? The GameStop saga gave rise to antagonism between these two forces with an urgency to pick a side. Whether retail investors or institutional investors are “right” to do what they do fails to address their distinctive impact on markets. What is more important is to focus on the facts: retail investors are now a significant part of the market that must be factored into how Wall Street does business. If not, firms will miss the opportunity to capture this new generation of investors and secure future profitability. 

Large-scale retail investor activity has put risky assets on a pedestal, and institutional investors must recognize this change to benefit from it. The retail investor universe is volatile on a good day, and filled with weird investments like NFTs and meme currencies. Hedge fund managers especially may have mandates that prevent them from making certain trades; several of the forum favorites, such as cryptocurrencies, lack any correlation with fundamental economic drivers, increasing their unpredictability. How can this world be taken seriously? The progression towards normalcy has been moderate, but developments like the first-ever Bitcoin ETF is a nod towards amateur-investor appetite for crypto. Bloomberg Intelligence reported that 85% of hedge funds and 42% of asset managers are scouring online trading boards to get a sense of what retail investors will do next. Big names, such as JP Morgan Chase, are creating data products that track securities targeted by individual investors. Most importantly, institutional investors are changing the way they invest, especially when they are bearish. At the end of 2021, only 7 stocks in the U.S market had short interest of over 40%, compared to 40 stocks in 2020 with short interest of over 70%. By striving to learn more about amateur investors and their focal points, institutional investors will be better positioned to advise clients that are interested in delving into riskier territory. 

Amassing individual investors as clients proves difficult considering that the internet is the preferred source for financial strategy. The internet, however, is overcrowded with misinformation and dubious investment advice, leaving newbie investors potentially vulnerable. Research conducted at Oxford finds that online chatter about particular assets is self-perpetuating, in that it amasses excited followers that act on the “hype” rather than on financial analysis. This phenomenon is referred to as herd behavior, and many have likely fallen prey to this investment style because of their lack of educational background in finance. An individual’s investment is essentially a bet on whether or not the herd is correct, and understanding whether the herd strategy was any good involves a grasp of market knowledge that many retail investors lack. This is exactly what large firms and institutional investors can market to retail investors: their knowledge. 

Financial professionals working in capital markets possess an educational background that gives them an edge over amateur investors. Risky bets can be taken at any level, granted, but the technicalities involved in crafting a sound investment strategy are simply not equivalent across the two camps. The golden opportunity for financial firms and institutional investors is to become a financial spirit guide, of sorts. A professional that has the background to provide market advice and knowledge, but that allows the so-called “DIY” clients to conduct their trading. The goal of this relationship would be to influence how amateur investors are engaging with the market by providing them with guidance that is in line with their ideals and high-risk appetite. Appealing to a younger, more rebellious generation is challenging for any industry - the advantage of this situation is that investment patterns are directly traceable online. Financial institutions are already searching the internet for the next big amateur investor move, so why not also take note of the forum characteristics, the most “liked” trends or investment ideas, and the tone of the general conversation to gauge how they can attract these investors? Would a low-cost forum generated by an investment bank, where bankers and individual investors bounce ideas off each other, be such a terrible idea? Providing advice in individual investors’ preferred medium and in their own terms may seem like a downgrade for financial institutions, but it could actually be a crucial business pivot that may allow them to develop a competitive advantage while increasing financial literacy. Retail investors can then pick up on market fundamentals that will assist them in making better decisions. As a moderately intended side-effect, volatility in markets will simmer down. 

The inevitable question is why would anyone seek any advice if they have already profited on their own? The answer is that day trading is strictly a short-term investment. The day trader aims to make a profit, and quickly. This is not a long-term investment strategy; the day trader has other priorities in mind that do not involve large capital expenditures, like mortgages, or an RESP for their children’s education. When these considerations start to surface, however, day trading may not be the ideal method to save for the future. Wealth management reaches beyond investing in markets because it is concerned with overall financial stability and planning. If a firm plays its cards right, it can attract younger investors now and foster those relationships in such a way that when priorities start to shift, these investors will turn to the firm for more concrete financial advice. Abigail Johnson, CEO of Fidelity, understands the importance of this new generation of investors for the future of Fidelity. She aims to increase accessibility by lowering fees on products popular with smaller investors, and pouring funds into building tech platforms for savvy users. Cultivating investors at every stage of their development is the key for firms to capitalize on this retail investor movement. 

Retail investors may trickle back to their 9-5 jobs once economies stabilize and pandemic fears have subsided. They may also take up day trading as a full-time commitment, as many have done so already. Regardless of the outlook, the reality is that retail investing is here, and it is both unpredictable and fervent. Financial institutions can benefit from this surge in individual investing by influencing how these new entrants engage with the market. With improved online resources and laissez-faire guidance, institutional investors can assist retail investors in making sounder investment decisions, which will cool down the volatility in markets. A strong relationship with a younger generation of clients can then help the institution secure business for the future, once the clients’ financial goals start to change. This perceived zero-sum game may be quite the opposite; David and Goliath may actually be more powerful if they join forces.