Ridiculed by professionals, “retail investors” are known for making terrible errors of financial judgement, including selling at the worst possible times, and keeping money in worthless investments. So what is a retail investor, and how do you avoid acting like one? To find out, ask yourself the following questions...
What is the difference between a stock and a bond?
What is the difference between nominal and real rate of return?
What is a P/E ratio?
What does a balance sheet tell you?
Why does the Federal Reserve raise interest rates to “cause” a recession?
What are the contents of a balanced mutual fund vs. an aggressive mutual fund?
If you do not know the answers to these basic questions, then you are a retail investor. That is, you are a person who invests money without really knowing what you are doing; therefore, you rely on news and opinions to make your investment decisions. What this article will explain then, is how to save you from yourself.
What marks the retail investor (RI) is fear caused by lack of understanding, occasionally accompanied by greed and Hubris - the belief that you know more than you actually do. The goal then, is to accumulate just enough understanding not to be a menace, while at the same time recognizing your limitations. The first step in this process is to understand how RIs behave, and how this differs from professionals. As a rule, RIs follow a pattern similar to the following scenario…
As the economy begins to recover from a recession, RIs remain sceptical (or scared and angry) and stay on the sidelines, putting their money into low-yielding GICs and money market funds, or under a mattress. They aren’t aware that when inflation is at 2% and their GIC yields 1.5%, they are actually losing money.
As the economy improves further and stocks begin to rise, RIs remain in cash. The market continues to rise, but with occasional drops (corrections) that keep edgy RIs out of the market, and leads them to believe that the market is "rigged" against them. Eventually, after stocks have risen significantly and the economy is well on its way to recovery, news stories of “excellent markets” begin to make headlines. At this point, RIs begin buying mutual funds and stocks in quantity.
The return of RI money to the market causes markets to rise. Seeing their stocks values improving, RIs get excited and put even more money in the market. Markets rise dramatically and stocks become overpriced. The fantastic economy makes front-page news. Neighbours of existing investors, not wanting to miss out on getting rich, join the party. News reports explain that this economy is different from all others before it (due to the Internet, Globalization, rise of China, or some other excuse) and that therefore the good times will never end.
Consumers –flush with cash - go on a spending spree that causes wage increases, labour shortages and inflation. Workers in their early 20s skip work to go to the beach, confident that if they get fired they will be able to find a new job within days. Industrial workers who normally don’t save a dime start buying as if they are high-rollers in Vegas.
The Federal Reserve begins to warn professional investors using cryptic phrases such as “irrational exuberance” or “froth” to describe the overheated market. Professionals start selling their overpriced stocks to euphoric mechanics and pizza-shop owners. To cool down the economy, the Federal Reserve raises interest rates so that fewer people can get loans to buy homes, cars etc. With the decline in business -- or in anticipation of it -- stocks drop slightly. Professionals buy bonds or put their money in cash.
RIs don’t worry about the decline in their stocks, because they know that the economy is doing spectacularly well: the media says so. Stocks drop more. RIs still feel confident. Stocks drop more, making the news. Although RIs begin to worry, they remind themselves that they are “long-term investors” and will simply wait for prices to rise again. Analysts warn of a difficult market. Consumers spend less. Stocks drop further. Finally, unable to sleep at night, RIs start selling their mutual funds.
A wave of selling brings reduced prices and still more selling. Panic sets in. Financial news anchors start babbling hysterically and arguing with their guests. Retail news agencies announce that we are in a recession, that life is terrible, and that the horrors may never end. Retail stock writers pen articles warning people that they may lose “everything.”
After days or weeks of frightening stories, financial news anchors finally run out of adrenaline and become gloomy and exhausted. The evening news tells the story of a lady next door who saves $10 a week by using cooking oil to power her car. Another story explains how to save money by using coupons. Shortly thereafter, Wall Street professionals announce that the stock market has hit a low plateau – all the retail investors have finished selling! Professionals buy. As they are buying, they make TV appearances warning retail investors not to buy, since it is still very risky.
And so the cycle continues…whether it be (as is this story) with stocks; or, with oil, gold, real estate, tulip bulbs, or frozen concentrated orange juice.
Although everyone knows that to make money in the market you have to “buy low and sell high,” retail investors typically do exactly the opposite: they are so afraid of losing money that they consistently lose money.
To be successful in the market, you must conquer your fears surrounding money. You must "buy low and sell high," which in practice means “buy pessimism and sell euphoria.” That is, you have to buy at a time when everyone else is afraid to do so.
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"They are stupid, the dumb money that always gets beat up. Retail waits until a stock works, and only then buys it. They they complain when it goes down. Or they won't sell something that works, convinced it's going higher, and then blame you when it blows up. Stay away from all of them. Use garlic and crosses if you have to."
Tom McDermott, as told to Andy Kessler in "Wall St. Meat"
