What is a retail investor?
A Retail investor is an individual investor that does not have a professional finance background and manages their own money. Retail investors are characterized by having a smaller portfolio than institutional investors and having less impact on the market due to the smaller size of their investments.
Retail investors usually invest in bonds or stocks, but some engage in trading and can even trade more complex financial products such as options or futures. However, most retail investors are not as knowledgeable about the markets and their inner workings as institutional investors.
There are two main ways of defining investors - institutional and retail. Banks and investment funds are considered institutional investors since they invest customers’ funds on the market. They are more scrutinized and have to comply with different regulations.
Retail investors, on the other hand, have fewer responsibilities and oversight. They can make their own investment decisions without following a particular set of rules. They can also allocate their capital in any way they see fit.
There are far more retail investors than institutional investors. However, institutional investors account for a much larger percentage of all the trades conducted in the stock market.
Every individual with a savings account, bonds, stocks, or some type of investment is considered a retail investor.
Institutional investors vs. retail investors
There are clear differences between institutional and retail investors, and the most significant is the portfolio size. Institutions either manage their pool of funds or clients’ money, so they have much more capital to allocate.
|Retail Investors||Institutional Investors|
|Small portfolio||Large portfolio|
|There are more retail investors||There are fewer institutional investors|
|Manages money for himself or his family||Manages money professionally for clients|
|Low impact on the market||Larger impact on the market|
|No regulation or compliance||Needs to comply with regulation|
|Not required to follow any strategy||Needs to follow a particular strategy|
|Access to less information||Has access to more information|
The most significant difference between retail and institutional investors is the portfolio size. Since retail investors manage their own funds, the capital they have access to is their savings or their family’s savings. Therefore the size of the portfolio is much smaller than the typical institution that manages its capital and client’s funds.
Impact on the market
Since retail investors manage smaller portfolios and usually trade fewer shares, their impact on the market is also smaller. Institutional investors manage larger portfolios, and when they buy a particular security, they can impact the market in a big way and have an immediate effect on the prices of a stock or bond, for example.
Regulation and compliance
While institutional investors have rules and regulations to comply with, retail investors have nobody to answer to. This means that their investment decisions can be made without worrying about the regulations they must follow.
Another essential factor distinguishing retail investors from institutional investors is the investment strategy used. There are several types of investment strategies you can use in the market, and a retail investor can choose the one that he or she sees fit.
On the other hand, institutions tend to have a well-defined investment due diligence and research process, and at the same time, some limits and restrictions to ensure every trade they make go according to their investment strategy.
Finally, one of the most significant differences between institutional investors and retail investors is the information that they have access to. Retail investors are often limited to reading the news and financial websites, but institutions have faster and more reliable access to market information.
This is perhaps the only significant disadvantage of being a retail investor since it can take a longer time to get the same information.
Pros of being a retail investor
While most retail investors believe that they are at a disadvantage compared to institutions that manage large portfolios, the fact is that a retail investor has a lot of advantages when it comes to investing.
Here are some of the advantages retail investors have over institutional investors:
Any retail investor can define and use whatever investment strategy they see fit. Institutions like banks or investment funds are often limited to following a specific process to research and evaluate investments.
For example, an investment fund that invests in stocks will often have a specific theme, meaning they will only buy particular securities depending on the fund’s theme. Here are some of the factors that investment funds often consider:
- Company location
- Sector and industry
- Size of the company
- Type of stock
Investment funds tend to stick to one single strategy, and this includes buying stocks in certain geographies or specific sectors or industries. Additionally, they will restrict the number of stocks they can invest in based on the size of the company and the type of stock. While some funds invest in both growth and value stocks, some are more restrictive and can only invest in one of the two.
This is a tremendous advantage for retail investors who can invest in whatever stock they see fit for their portfolio without following an imposed predefined strategy.
Because institutional investors manage money for their clients, all of their investment decisions will be reviewed and carefully analyzed by investors. This restrains the freedom to make specific investment decisions.
This affects the investments chosen and the way each portfolio is built. While institutional investors may be required to diversify their holdings, retail investors can have very concentrated portfolios. It also affects how risk is managed, and therefore retail investors can take on more risks without having to worry about what their customers will say.
The most significant difference between institutional investors and retail investors is the size of the portfolio. Still, while this may seem like a disadvantage for retail investors, it is a great advantage.
Due to the large size of the institutions' portfolios, they cannot invest in specific securities. For example, a small-cap stock with a market cap of just $50 million is not a suitable investment for a large investment fund with a portfolio of $20 billion. The reason is that the fund would have a very small exposure to the stock, and buying it in large quantities could affect his price significantly.
Additionally, a small-cap stock is less liquid than a large-cap stock, and investment funds cannot buy illiquid investments. This means that most large institutional investors cannot invest in thousands of stocks. Leaving a lot of untapped investment opportunities for retail investors to generate above-average returns by researching and investing in companies that most institutional investors do not follow.
Institutional investors are overseen by different entities, both internally and externally. They need to comply with regulations and the firms’ own rules and have paperwork to submit every month. Retail investors do not have the same level of scrutiny, allowing them to have more control and freedom over their investment decisions without having to spend any time filling in paperwork.
Outflows and inflows
Institutional investors, like investment funds, are dependent on their client’s money to have access to capital to invest. This means that if investors start pulling money out of the fund, they will have to sell specific holdings in their portfolios, or if there are inflows of the client’s funds, they are forced to allocate that capital.
This means that an investment fund may be forced to buy or sell securities based on inflows or outflows of capital, which can directly affect their investment decisions. Retail investors are not constrained in the same way, so they have more freedom to make their investment decisions.
Institutional investors are paid to manage money and achieve returns for their clients, creating short-term pressure on the results they achieve. Every institution that invests money has short-term goals, and this influences their investment decisions. They can’t have their client’s funds uninvested or wait for a particular signal to buy a specific stock.
This is an excellent advantage for retail investors because they can take as much time to research and make their own decisions whenever they want. They can take as much time to research and evaluate an investment before making a decision.
Retail investors are also not pressured by their short-term performance and can underperform the market for a long time without worrying about their clients’ being unhappy with the returns.
Retail investors also have access to s tax benefits on their investments, for example, through a 401k or a Roth IRA, they can avoid being excessively taxed on their investments. This is yet another advantage of being a retail investor that is often overlooked and forgotten by most retail investors themselves.
Lower taxes on the returns generated allow investors to compound their money, sometimes tax-free.
Cons of being a retail investor
While there are plenty of advantages to being a retail investor, there are also some clear cons:
Due to the smaller portfolio size, retail investors usually incur higher fees relative to the amount of their investment. This is certainly a disadvantage, and if you start with a small portfolio, some fees might represent a large percentage of your portfolio and each trade.
However, one way to overcome this disadvantage is to use a broker that does not charge any feeds.
Less access to information
Institutional investors have more access to information and news than retail investors. Not only do they get more information, but they also usually get it faster, which can be a great disadvantage for retail investors. Additionally, institutional investors have multiple employees working on any given investment, making it easy to research investment opportunities. Retail investors are on their own and have nobody but themselves to help them make investment decisions.
Overall being a retail investor is more advantageous than some would think, as it allows you to go unnoticed in the markets, which can be a great advantage. You also have absolute freedom to choose your investments and manage your portfolio in the way that you see fit.
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