Although professionals are generally considered to be the experts, some research reveals that retail investors did a better job of forecasting the financial crisis than professional money managers.
The laity often assumes that professionals are the experts in any given endeavor. The experience of retail investors in the United States, however, seems to tell a different story. Individual investors are savvier than many might believe.
How Is This Article Useful to Practitioners?
So-called smart money might not exist. According to the conclusions of a recent paper by researchers at the Federal Reserve, professional investors might have less of an effect on markets and make less accurate forecasts than US retail investors.
The researchers gathered data on individual investor behavior through recurring surveys conducted by Thomson Reuters and the University of Michigan to obtain investor views on economic conditions. From this information, they put together an index that measures when opinions on the economy are most divided. The results were, in turn, compared with those of professional econometricians expressed in numerous surveys.
Retail investors’ views diverge most just before a recession, whereas those of the professionals diverge at the tail end of one. From these findings, it would appear that finance professionals are less adept at forecasting than retail investors. The multiple locations and different backgrounds of retail investors contrast sharply with those of the more uniform group of professional investors—facts that could explain the result.
As a further robustness check, the researchers compared the divergent opinions of the retail investors with trading volume and mutual fund flows. Activity in both areas increases with more division among investor opinions. In contrast, little impact on trading from the professional investor group was observed.
The author notes that the opinions of older, wealthier, and better-educated investors are more likely to affect stock prices than those of other investors. Additionally, the stocks most influenced are blue chip shares, which are well known to the average investor.
Traders and students of behavioral finance would find this research interesting. For financial advisers, it is a wake-up call, and they need to tailor the message to their clients accordingly.
The tentative conclusion of the researchers’ study is that group think is group stink. The retail investor experiences the effects of the economy on his or her portfolio directly and is well positioned to offer insight. The broader the sampling, the richer the output may be. A more comprehensive study of the investing acumen of retail investors would be worthwhile. Perhaps focusing on age and demographic subsets of the population could yield additional insight. Additionally, taking the researchers’ approach to other countries with strong equity cultures—adjusting for local peculiarities—could produce interesting results. Both exercises could be fodder for greater insight into investor behavior for the professional adviser.