What Is A Retail Investor? Types Of Investors Explained

Key Takeaways:


The democratization of the stock market by new trading platforms has led to the revival of retail investors. Today, more so than ever, retail investors are making their presence felt in US equity markets. Retail investors are impacting the market in ways each of the major indices have never seen, which begs the question: What is a retail investor? Better yet, how are they altering the way people invest in the stock market?

What Are Retail Investors?

Retail investors are the antithesis of institutional investors. Whereas institutional investors have become synonymous with large-scale, professional money managers, retail investors are simply the opposite: non-professional investors who buy and sell stocks in significantly smaller increments. Perhaps more specifically, however, retail investors are anyone with expendable cash and an inclination to invest it in the stock market. In doing so, retail investors will traditionally invest relatively small amounts of their cash through traditional online brokers.

Despite their modest individual allocations, retail investors play an essential role in the market. With somewhere in the neighborhood of 100 million retail investors participating on Wall Street, modest retail investments can amount to significant market moves. As a whole, retail investors make up a large portion of the most popular indices.

Retail investments are an invaluable component of the stock market ecosystem. Individually, retail investors may not invest anywhere near as much as institutional investors, but their cumulative investments move the market nonetheless.

How Retail Investing Works

In its simplest form, retail investing can be broken down into as little as seven steps, including:

  • Define retail investing goals: While it is safe to assume all retail investors are buying securities to increase their net worth, investing in the stock market is merely a means to an end. It is worth noting, however, that everyone’s endgame is unique. Some retail investors will day trade for quick results, while others will buy and hold to supplement their retirement. With that in mind, aspiring retail investors must first determine what they want out of the market before they get into it.

  • Educate yourself on the stock market: Before investing a single dollar in the stock market, retail investors are strongly advised to learn how securities trade. More specifically, retail investors must educate themselves on how things work. Doing so will ultimately help them make better decisions and increase their odds of realizing success.

  • Set a budget: Most retail investors are small-time investors, at least compared to institutional money managers. As a result, most are working within a predetermined budget. That said, it’s not enough to simply put a little bit of money in each paycheck. Retail investors need to carefully consider how much they can invest each month without sacrificing necessities. It’s important only to invest money that won’t be needed for at least a few years. Doing so ensures retail investors are in it for the long haul and won’t have to pull money out when stocks are down.

  • Prioritize investment strategies: There are several ways to invest in the stock market. Retail investors may choose to invest in long-term securities, dividend stocks, mutual funds, exchange-traded funds, or they can even day trade if they are up to the task. Each strategy comes with its own risk/reward profile, and investors need to determine which strategy complements their own goals.

  • Open an account with a brokerage: Once retail investors have done their due diligence, the next step is to sign up with a brokerage. Today’s best brokerages are easily accessible, can be signed up for quickly, and offer several investment tools. That said, not all brokerages are created equal. Investors will want to pick the broker that meets their needs the best.

  • Build and manage a portfolio: Once retail investors are signed up with a broker, the next step is to build and manage a portfolio. Simply put, this is the step where investors will deposit funds and buy securities.

  • Diversify your holdings: Retail investors need to diversify their holdings between what they deem to be good securities. If possible, investors should try to hold at least 15 to 25 different securities; that way, they mitigate the risk of a single stock disrupting their entire portfolio.


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Retail investments

The Impact Of Retail Investors

At first glance, it would appear as if retail investors don’t account for a significant portion of the US equity markets. If for nothing else, the average retail investor is working with far less capital than even the smallest institutional investors. However, it’s important to note that retail investors (or American households) make up most of the market.

While individual investors may not invest as much as institutional investors, there are a lot of them—upwards of at least 100 million. According to the Security and Exchange Commission (SEC), retail investors represent about $29 trillion (approximately 58% of the US equity market), either directly or through holdings in retirement accounts, mutual funds, and other investments.

Retail investors already impact the market significantly, and there’s nothing to suggest the trend won’t continue. The advent of commission-free trading apps like SoFi and Robinhood has recently introduced an entirely new generation of investors to the market, granting any qualifying retail investor access to a tremendous wealth-building opportunity.

With retail investors already making up the majority of the market, and many more expected to enter the pool in the immediate future, it’s safe to assume the impact of retail investors will only continue to grow. At the moment, the cumulative efforts of nearly half the households in America are enough to drive stocks up and down.

Now, more than ever, retail investments are making a meaningful difference. Throughout the pandemic, in particular, retail investors have been able to work together and pool their efforts over various social media platforms. Segments of the retail community have even driven up the price of so-called “meme stocks” in a unified movement against short-sighted hedge funds. At the very least, the collaborative efforts of retail investors have created volatility across all of the indices; at the most, however, retail investors have changed the landscape of the stock market entirely.

Pros Of Being A Retail Investor

The pros of being a retail investor are significant and well documented. That said, if any aspiring retail investors are looking for more of a reason to start investing, they may want to consider the following:

  • Small and/or fractional investments: Most retail investors use today’s most popular brokerages, many of which award their clients the ability to buy in small or fractional sums. As a result, retail investors can buy shares in just about any company, regardless of their share prices. That way, investors with limited access to capital can buy into today’s greatest companies.

  • Relative liquidity: The same brokerages that offer fractional shares also grant their customers a high level of liquidity. In most cases, retail investors can gain access to their money the moment they sell a stock. While some will have holding periods, it’s safe to say retail investors can liquidate their holds quick and easily.

  • Invest with ease: Investing in US equity markets is easy. Individual investors need to deposit funds into their brokerage and purchase shares of the companies they want. Investing successfully, however, requires a lot of due diligence and even more patience. Nonetheless, today’s emerging brokerages are democratizing the act of investing and making it easier than ever.

  • Potential profits and cash flow: Needless to say, the stock market can be a great wealth-building vehicle for those who know what they are doing. The average stock market return has been approximately 10.0% per year for the better part of a century. Returns will vary from year to year, but investors who stick to the benchmark indices can expect about a 10.0% return every 12 months.

  • Diverse Investment options: Retail investments may be as diverse as the investors making them. If for nothing else, there are countless ways to invest in equity markets. Retail investors, for example, may choose to play the long game or the short game. Additionally, individual investors can prioritize growth, value, cash flow, or even speculative stocks. Institutional investors, on the other hand, are usually beholden to pulses that govern their specific allocations.

  • Invest in personal interests: Retail investing allows investors to invest in companies they truly believe in or like. For example, it’s entirely possible to invest in a portfolio that matches your personal beliefs.

Cons Of Begin A Retail Investor

Not unlike every investment strategy, there are downsides to being a retail investor, not the least of which include:

  • Fees: In order to maintain their business models, today’s most popular brokerages will charge fees for their services. Fees will vary from broker to broker (and from the services provided), but retail investors can expect to encounter some fees along the way. Some brokers, for example, will charge fees for investing in foreign or over the counter (OTC) stocks; others may charge fees for buying and selling securities.

  • Payment for order flow: Some brokerages promote “free” trading platforms, but what they don’t tell you is how they are providing shares to their customers. More often than not, they sell shares at a slightly higher price and give the difference to a market maker. Otherwise known as payment for order flow, this process may not coincide with fees, but it also prevents investors from buying shares at the best prices possible.

  • Inexperience: By nature, retail investors are typically less experienced than their institutional counterparts. Not all retail investors are inexperienced (many are experienced veterans in the market who have realized years of success), but rather that most individual investors are less prepared than institutional traders.

  • No primary market access: Retail investors aren’t granted access to the same primary market that institutional investors are. Without getting into too much detail about the primary vs. secondary market, retail investors have to wait until shares pass from the primary market to the secondary market, which means higher prices.

What Is An Institutional Investor?

An institutional investor is a large organization, usually a bank or an insurance company, seeking to grow its net worth by investing significant capital in US equity markets. Not unlike individual investors, institutional investors will seek to grow their wealth by investing in promising securities. Unlike their retail counterparts, however, institutional investors are professionals with access to large sums of money.

Types Of Institutional Investors

Institutional investors are large business which can take the form of many different types of entities:

  • Pension Funds

  • Mutual Funds

  • Hedge Funds

  • Investment Banks

  • Endowment Funds

Pension Funds

Pension funds are one of many types of retirement plans. As such, pension funds team up with employers and promise to pay employees throughout their retirement. To do so, the employer sets aside money in a fund on behalf of the employee. The money in the fund is usually allocated amongst long-term, low-risk investments to ensure that there’s money upon retirement. The funds are tax-deferred, which means the retired employee will be expected to pay income tax on the money they receive. In return, employers are awarded a lucrative method of deferring current wages and salaries to retirement savings.

Mutual Funds

A mutual fund is an institutional investor that pools the funds of individual retail investors together to invest large sums of money into US equity markets. Therefore, mutual funds are essentially qualified money managers. Investors will choose which mutual funds meet their investment styles and invest their capital accordingly. The mutual fund will then split the collectively pooled capital and divide it amongst a predetermined “basket” of stocks, bonds, money market instruments, and similar assets.

Hedge Funds

As their names suggest, hedge funds rely on a pooled investment strategy that allows participating investors to benefit in just about any market. Staying true to their name, hedge funds attempt to minimize risk and maximize returns simultaneously. That’s not to say hedge funds are void of risk, but rather that they hedge their bets to minimize downside. However, it is important to note that hedge funds are less inclusive than most institutional investors; their spots are reserved for accredited investors, usually up to about 35 in total.

Investment Banks

Aptly named, investment banks specialize in buying shares on the primary market and selling them to investors on the secondary market. Not unlike an intermediary, investment banks will serve as the bridge between corporations and the financial markets. More specifically, investment banks will help corporations issue new shares of stocks in an initial public offering or an additional stock offering. It’s the investment banks that underwrite IPOs and decide the prices stocks will begin trading at.

Endowment Funds

An endowment fund is money set aside to earn revenue to fund some type of charitable activity. Endowment funds work like trust funds; only the beneficiary is a charity instead of a person. As a result, endowment funds are commonplace at churches, universities, hospitals, and other non-profit organizations. Investment income is used to fund the respective charitable activity

Summary

Retail investors are an integral part of the US equity markets. While their individual contributions may not be as large as institutional investors, the market is composed primarily of retail capital. As a result, retail investors exercise a great deal of influence over market volatility. Perhaps even more importantly, the recent influx of retail investors created by commission-free trading apps is expected to increase the number of individual investors in the market. The so-called democratization of Wall Street will not only open the doors for more people to build wealth, but it may even give retail investors more power in the market (if it hasn’t already).


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