I once worked at a Wall Street shop which employed a very interesting capital markets strategist. Like most other Wall Street strategists, he had his estimates, charts and thoughtful opinions. He was well educated and quite articulate. His views always seemed reasonable, logical and probable. His unique claim to fame was this – he was always wrong. In fact, one client of the firm loved him very much exactly for this trait. They would listen to him very carefully and then do the exact opposite. This client paid the firm very well for his “guidance.” They said that he made them lots of money doing this.
Like many bizarre stories, this one doesn’t have a happy ending. One year, this strategist was uncannily accurate in nearly all of his calls for the year. Interest rates, currencies, the stock market, and so forth all moved exactly as he had predicted. As he was basking in the warm glow that comes with being right about complex functions such as the capital markets, the sales person covering that one big client who liked him as a contra-indicator called with bad news. They were cutting off the firm because he had disappointed them by being so right!
There is another group of investors whose claim to fame is always being wrong – the individual investor. Now, before I suffer the wrath of millions of smart, outperforming individual investors, please let me explain what’s behind this reputation.
In theory, stock prices are supposed to discount (that is already account for) all things known and expected by all investors. This is why we sometimes see the “buy on the rumor, sell on the news” phenomenon. So-called “smart money” (people like Warren Buffet, the best hedge fund and portfolio managers, big bank prop traders, etc.) will usually buy something well before the good news becomes obvious. It’s not that they have insider information or really “know” something is going to happen, it’s that they do this full time, have enormous resources at their disposal and are backed by many years of experience. They understand the distribution of probabilities, are often able to measure which outcomes are more likely, and consequently deploy capital in an effort to profit from those expectations.
Let’s contrast this approach to that often used by the individual or “retail” investor. The “average” investor in this group likely does not invest as a full-time job. He or she may get investment ideas from a relative or a friend. Maybe the source of investment inspiration comes from a magazine, newspaper or TV show. Often the idea is “sold” to the investor by a well-intended (perhaps) person who may or may not have an ulterior motive. Most of the time, this “great” investment idea sounds logical, plausible and compelling. The problem with this approach is that more often than not, the potential of this great story stock is already priced in. “Smart money” bought the stock a while back and has already made the bulk of return (notice how most “great” investment ideas involve stocks that are up a bunch?). Retail investors are left with the scraps and often the losses.
As a group (clearly there are retail investors who invest well and achieve above-market returns), retail investors are very good at one thing: investing heavily in the thing that just worked well. We can see this when we look at the sum of all retail portfolios and measure the aggregate asset allocation. Retail investors held a record amount of stocks (as a percentage of the total) in 2000, just before the tech bubble burst and the market collapsed. Their largest cash holding ever came in early 2009 as the stock market was bottoming and fear was peaking. Bonds peaked as a percentage of the total sometime last year. We shall see how that works out for them…
In the Wall Street Journal over the weekend, Jason Zweig (one of my favorite market commentators) asked the question “Will Small Investors Ever Warm Up to Stocks Again?” In his piece, he notes that retail investors, acting precisely as expected, have shunned stocks even after the huge run the market has had. If they began to aggressively embrace stocks, he notes (and I concur), it may be a yellow flag for the market.
I have my own theory about this. I think the retail investor is sick and tired of always being wrong and will shun stocks for the entire cycle! That way they won’t be wrong this time. How they all got together to decide this is still a bit of mystery to me. Maybe they are all using Facebook or something. If I’m right, we may have to measure the next peak in the market without the help (?) of the resilient retail investor, who despite this bad rap, continues to invest in risk assets. If I’m wrong, we will likely see a resurgence of retail investor interest in stocks, no doubt peaking just as the market does. Time will tell.