Why Retail Investors Aren't 'Dumb Money' and Where They Have an Edge

Charles Rotblut, vice president of American Association of Individual Investors, joined The Long View podcast to discuss his thoughts on the institutional versus individual investor, the popular AAII Sentiment survey, and the long-term investing strategy.

Here are a couple of excerpts on the competitive advantages of individual and institutional investors and the perceptions of investor knowledge, from Rotblut's conversation with Morningstar's Christine Benz and Jeff Ptak:

Are Institutional Investors Really 'Smart Money'?

Ptak: More broadly, we often hear individual investors characterized as the dumb money in the market. So, first question is, do you agree with that assessment that individual investors are the least informed? Or do you think that's overblown? And then, my second question is, how has your perception of individual investors' knowledge of the market, how has that changed through the years as you've observed your membership? Rotblut: That's a great question. And I would say, there's probably almost a difference between knowledge or wisdom, and it's probably even more so access to data versus behavior. And the reason why I say that is, when you look at a lot of people running the institutional money--so they are "smart money"--I commonly hear that a lot of professional money managers are hired or fired based on a three-year performance. So, you have these committees making decisions for pensions, making decisions for endowments, and they're very short-term focused, which is a really terrible behavior. And it makes it tough for people who are following, say, a value strategy that is prone to periods of underperformance because they always have to worry about the relative performance. And we even see that the mutual fund managers where they're often just trying to stay close to the benchmark or trying to stay just ahead of their benchmark, as opposed to saying, "You know what, I'm going to really be active, and I'm not going to worry about straying from my benchmark because I know if I stick with the strategy over 10 years, my clients are going to be very happy with my returns." So, I think there's a lot of bad behavior on the part of the institutional side that really doesn't get talked about. And I also would point out when you look at the big moves in the markets--yes, for individual stocks, say, your GameStops, your Bed Bath & Beyonds, your AMC--there are individual investors driving those stock prices. But when you look at the big market moves, it's often the institutional investors that are really moving the market. So, individual investors, is there varying levels of competence, is there varying levels of investment knowledge? Absolutely. But I don't think you can necessarily say that individual investors are the dumb money, and all the unknown institutional investors are the smart money. I think there's a lot of nuances in between, and a lot of reality that actually goes on that gets overlooked that's overshadowed by trying to paint both groups with separate brushes.

Individual Investors Can Play the Long Game

Benz: What competitive advantages do small investors have that pros don't?

Rotblut: I think the biggest advantage is never having to report your performance. And I cannot understate how big an advantage that is, because when you're a professional, and you have to report your performance, or maybe you're an endowment, and you're running the endowment, and you have to report your performance to the boards, you're under pressure in terms of that short-term performance, and you're under pressure to achieve a certain level of return. But when you're an individual investor, you're really saving for your goals. So, you're playing a different game. If your goal is retirement, then it really is at the end of the day getting enough money saved to fund retirement and as you transition toward retirement, thinking about, well, I need to start taking withdrawals, so maybe I give up a little bit of a return now to ensure that if short-term volatility hits the day I retire, I'm not having to sell part of my portfolio. I think it also gives individual investors the ability to follow longer-term strategies, such as small-cap value, which has a great long-term track record, but can be very volatile over the short term. And so, I think, really, if you're going to be a stock investor, an individual stock-picker, you really want to be someone who's trying to be truly active. And when I say truly active, I don't mean actively trading, but I mean being different than the index, having a portfolio that looks a lot different than the S&P 500 or looks a lot different than the Russell 2000. Because that's where you're going to have your edge going into the stocks that are less looked at, less frequently traded, less talked about--you're going to find more mispricing, and that's where you're going to have a bigger advantage. But to invest in those stocks, again, you have to be willing and have to be very comfortable with earning a return that's different than the market. And if you're not comfortable with that, index funds work really well and there's nothing wrong with it, but that just means that you're making a conscious choice not to be an active stock investor, but to take comfort in the role of index funds. And that's a perfectly fine way to invest. Every person is a little different in terms of their investment preferences and in terms of what type of investing they're comfortable with.

This article was adapted from an interview that aired on Morningstar's The Long View podcast. Listen to the full episode.