If Retail Investors Are Dumb Money, Who Is Raking Up All The Alpha?

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Here’s a follow-up to my post about the return gap of retail investors due to poor timing. For every seller of a stock share, there is a buyer. Therefore, if the timing of retail investors is reliably a little worse than average, we also know that someone else is on the other side of all those trades. Is there a group of non-retail investors that is reliably making money off the “dumb money” trades of retail investors?

Larry Swedroe digs into this question in his Advisor Perspectives article The Suckers at the Investment Table:

New research confirms that institutional investors, such as mutual funds, outperform the market before fees, and they do so at the expense of retail investors. That is bad news for retail investors and for investors in active mutual funds, who underperform after fees.

The research finds that the stocks and bonds individual investors buy go on to underperform and the ones they sell go on to outperform – demonstrating that retail investors are “dumb money.”

Unfortunately for fund investors, the same large body of evidence demonstrates that while mutual funds generate gross alpha, their total expenses exceed gross alpha, resulting in negative alphas for their investors.

If on average, an actively-managed mutual fund generates 0.7% of gross alpha, but after you subtract the expense ratio and trading costs which add up to nearly 1%, the net alpha is still negative. The active manager is the winner, taking all of the alpha for themselves in the form of relentless fees taken as a percentage of the entire asset base. The retail investor/customer still loses out. An fairer fee structure would be to take a larger percentage, but of the alpha only.

People will continue to argue about this, but I’m not surprised to see that these studies found alpha. It’s just much, much harder to do than most people think, and that’s exactly why you almost never see a fee structure based on alpha (thought they do exist). Even Charlie Munger, who is famous for his stock-picking skills and disagreement against the “hard” form of Efficient Market Theory, only says that the top 3% to 4% of professional investment managers will outperform (source):

I think it is roughly right that the market is efficient, which makes it very hard to beat merely by being an intelligent investor. But I don’t think it’s totally efficient at all. And the difference between being totally efficient and somewhat efficient leaves an enormous opportunity for people like us to get these unusual records. It’s efficient enough, so it’s hard to have a great investment record. But it’s by no means impossible. Nor is it something that only a very few people can do. The top three or four percent of the investment management world will do fine.

In the end, costs always matter. If you find a genius to pick stocks but they cost more than they help, then you still lose. The only actively-managed mutual funds that I have seriously considered buying are from Vanguard, which improves the odds with substantially lower expense ratios and a history of investor-friendly practices. As a DIY individual investor buying index funds, you can keep your head down and “grind out” reliably above-average returns over time due to the rock-bottom costs. (There, I fit in my own poker reference!) Even as a DIY individual stock investor, as at least I understand what I own and don’t have to pay a 1% management fee every year.

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Comments

  1. I hold an individual stocks portfolio and an index funds portfolio. I feel great about the former right now since all I do is buy and hold so it’s all paper gains. Someday I’ll start selling for income and I often wonder if I’ll feel like a dumb retail investor then 🙂

  2. This is one of the best posts for the average person who invests in the stock market. I would even add that if you aren’t worried about a stock manager messing up your returns because he had a bad day or whatever reason you can focus on developing more skills and increasing the money you generate. (Then there is more money to invest and live off of)

  3. I have wondered for a while whether index or similar funds would experience the returns they do without the “smart money” trying to beat the market. If everyone shifted their money to index funds, the market would lose much of its efficiency. If this is true, it almost seems like the differential between the returns that “smart” investors experience and what “dumb” investors experience is a market efficiency tax (which everyone benefits from but the smart money investors pay).

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