If You Don’t Know What an Institutional Investor is, You’re Probably Not One
The distinction between retail and institutional investors is one not many investors can make, but understanding it is worth your while. Your wallet will thank you.
Who Are They
Retail investors, also known as individual investors, make up the majority of all investors, though they are only responsible for about a quarter of all investments (by capital). The other three quarters are all composed of trades made by institutional investors.
Institutional investors are made up of organizations and entities that invest on behalf of their members. These organizations invest much more than your average retail investor. They include hedge funds, pension funds, trust funds, mutual funds, insurance companies, and even some private equity funds.
The Institutional Edge
Institutional investors are typically more experienced and have far more information at their disposal because of their larger share of the market. They put in more time researching investment opportunities before opening up their wallets. Retail investors, on the other hand, are criticized for making uninformed investment decisions due to impulsivity as well as a lack of knowledge and discipline, resulting in bubbles and jeopardizing the market’s efficient allocation of capital. As a result of this, governments have put more restrictions and guard-rails in-place applying only to retail investors, so as to avoid them from making overly risky investments. On top of all of this, they pay hefty trading fees while institutional investors pay little to none. This equates to a massive disadvantage to the majority of traders in our economy.
Block trades are the buying or selling of a large cluster of stocks and bonds at a set price by two parties, containing 10,000 shares or more (not including penny stocks), or $200,000 worth of bonds. Since these trades are of such high volume, they are usually bought and sold in private for a discount to market value. They are sold outside of the open market to circumvent drastic changes in a stock’s price, which would otherwise happen if the addition of the block trade volume exceeds the average volume a stock encounters on any given day. The reasoning is sound but represents just another edge that institutional investors have over retail.
Most markets are shared by both groups of investors, but there remain two that are left occupied entirely by one. Those two markets are the swap agreement market and forward contract market, and unsurprisingly, that sole occupying group is institutional investors. I won’t go into details about how they work here but rest assured, InvestBETA will be covering them when we delve into derivatives later this year.
The Gap is Closing
There is certainly inequality between institutional and retail investors, but there is reason to be hopeful. The democratization of information through the internet, faster trading times with mobile apps, and lower brokerage fees are all enabling retail investors to manage their portfolios more actively and make more informed decisions.
It’s been less than 11 years since the Tax-Free Savings Account (TFSA) was introduced, and Statistics Canada estimates that already more than 40% of Canadian households are in possession of one. The TFSA was a huge step taken by the Canadian Government to encourage citizens to save their money, though not everyone expected the TFSA to take the direction it has in the past decade. More than 60% of users are working their TFSA as not just a vehicle for savings, but for investment, and this is only becoming more common. In truth, it should be called a TFIA, for Tax-Free Investments Account. The 401(k) in the USA is similarly very popular for investment but has been around for much longer. The power of these accounts is only growing with the explosion in smartphone technology and access to the internet.
Common people can have access to live stock prices; we can catch wind of news almost if not just as fast as investment bankers; we can buy and sell shares in mere seconds. It’s hard to imagine that not too long ago, the only way to trade stock was to drive down to the closest trading floor. You would then have to shout your offer as loud as you could in the hope that someone interested would hear it, whereafter you would write it in your notebook and all the trades would be settled at the end of the day. We’ve come a long way. Barriers are breaking, and the gap is closing.
Conclusion
The difference between retail and institutional investors is one that every investor should be able to make. Because despite all the red tape and more access to information, retail investors are still commonly the cause of many market bubbles. A stereotype often portrays them as reading a headline from The Motley Fool or BNN Bloomberg and blindly buying shares without any further research or due diligence. It’s important to understand this, not only to avoid adding to that stereotype, but to have a better understanding of the market.
Retail investors are often the cause of market bubbles, though funnily enough, bubbles pop. And once you begin to understand what makes headlines, what makes investors come to their senses, you can begin to understand when a bubble will pop and the market will correct to the proper allocation of capital. The stock market is all about trying to predict where the market will go and when. Your predictions will only get better if you get better at correlating market events with changes in market sentiment. That’s something nobody can teach you, but I hope I’ve pointed you in the right direction.
Key Takeaways
- Retail investors are individuals who invest their own money and make three-quarters of investors but only one-quarter of investments
- Institutional investors are organizations who invest on behalf of their members and make up three-quarters of investments
- Institutional investors have historically had an edge over retail investors due to their larger share of the market
- Because of recent innovations, the gap between retail and institutional investors is getting smaller
- Despite the closing gap, retail investors are commonly the cause for market bubbles
- It’s crucial to learn what makes these bubbles pop but that’s something only you can learn for yourself
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