May 26, 2022


Skillful Business Crafters

Why retail investors ‘are very good for markets,’ according to one researcher

Despite the backlash to the turbulent meme stocks that rose to prominence in 2021, the retail investors who helped fuel a volatile stock market may actually be a force for good.

“I think retail investors are very good for markets,” Jan-Oliver Strych, assistant professor of finance at Karlsruhe Institute of Technology in Germany, told Yahoo Finance Live (video above). “In academic literature a long time ago, a lot of studies said they are uninformed, they are overconfident. But I think more recent research shows that they are informed, in fact.”

A December 2021 study that Strych co-authored with fellow Karlsruhe professor Felix Hüfner found that stocks likely held by retail investors had 17 percent higher liquidity and at least 24 percent lower crash risk.

“What we saw is that in times of stress, of market trauma… retail investors provide liquidity to institutional investors that are forced to do fire sales in this stressful situation,” Strych said. “By doing so, they actually decrease the impact of pressures during the pandemic.”

The results of the study were not surprising to Strych, who noted that institutional investors retreat from the market in the face of financial crises (like that brought about by the pandemic). These new retail investors helped stop the bleeding, in a sense, by buying cheap stocks which were hurt by institutional investors’ withdrawals in order to provide greater liquidity.

Although recent data have suggested that retail investors now have greater access to information than in years past, the study does not explicitly say one way or the other whether these investors are driven by good information.

“Our study does not say that retail investors are actually informed. We can’t say something about that at this stage,” Strych stressed. “But what we can find here in our study is that retail investors are rational.”

To this end, the study found that retail investors respond to volatility and are more likely to invest in more stable, less-shorted stocks.

Keith Gill, known on Reddit under the pseudonym DeepFuckingValue and as Roaring Kitty, is seen on a fragment of a youtube video displayed on a smartphone screen in front of Reddit logo. (Photo Illustration by Pavlo Gonchar/SOPA Images/LightRocket via Getty Images)

Retail investors and the rise of the ‘meme stocks’

Retail investors swarmed the market after the onset of the coronavirus pandemic. 

In January 2021, GameStop (GME) stock rose sharply to over $300/share at its peak. The phenomenon made national news headlines due to the massive activity associated with the stock — at one point, nearly a million people traded GME in one day.

The company had demonstrated relatively poor financial performance for the past few years, which led experts to a general consensus that the video game retailer was in a period of decline. Many hedge funds and institutional investors sought to capitalize on the company’s misfortune through short-selling, a practice that bets against a stock and only reaps a profit if its value drops.

Driven by a combination of anti-establishment sentiment, social media forums like r/WallStreetBets on Reddit, and the influx of extra money from the stimulus, several meme stocks experienced meteoric rises during the first half of 2021.

People walk by a GameStop in Manhattan, New York, U.S., December 7, 2021. REUTERS/Andrew Kelly

People walk by a GameStop in Manhattan, New York, U.S., December 7, 2021. REUTERS/Andrew Kelly

Millions of retail traders ran to the stock market to purchase GameStop stock, driving the stock’s price up several hundred percent to the chagrin of more established traders who had been writing the video game retailer’s obituary.

And GameStop wasn’t the only company to experience a turbulent 2021. AMC (AMC), Bed Bath & Beyond (BBBY), and Upstart Holdings (UPST) were all considered meme stocks that confounded market forecasters and experienced tremendous growth this year.

The advent of commission-free trading at brokerages like Robinhood helped fuel meme stock trades. Recently, however, a growing number of restless retail investors have begun pulling their meme stocks from brokerages to prevent their shares being lent to hedge funds for short-selling. 

This trend, which involves registering stock ownership in the investor’s name instead of a brokerage, has gained momentum since September, when concerns regarding the lending of shares to brokerages became a popular topic of discussion on Reddit. If it is sustained, it could spell trouble for the brokerages that profited from the infusion of retail investors in the market during the pandemic.

Ihsaan Fanusie is a writer at Yahoo Finance.

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