No, retail traders aren’t the smart money

Ever since the GameStop short squeeze, I hear how retail traders have become the new force to reckon with in stock markets. The argument goes something like this: Electronic trading has become cheaper and more widespread for retail investors. On top of that, there are social media platforms that allow retail traders to “coordinate” and hype individual stocks which then experience massive share price gains. As a result, professional investors need to predict retail investors’ next move in order to figure out which stocks to buy or sell. If the article is a bit more sophisticated (and let’s be honest, hardly any articles on this topic are), then the “evidence” given in support of the power of retail traders is that stocks that are bought by retail traders experience high abnormal returns in the one to five trading days after they have been bought by retail traders.

Short-term abnormal returns in stocks bought by retail traders

Source: Barber et al. (2021)

However, as Brad Barber, Terrence Odean, and Shengle Lin have recently pointed out, this doesn’t mean that retail traders are making money. The average return for retail traders in their portfolios over the one to five days after they bought a stock is negative. It gets worse: The research shows that small trades made by smaller and presumably younger retail traders perform even worse than larger trades.

Short-term abnormal returns in retail traders’ portfolios

Source: Barber et al. (2021)

How is that possible?

The researchers solve this paradox by emphasising some important facts about how retail traders invest and how the first chart above is generated.

First, when calculating the abnormal returns in stocks bought and sold by retail traders, this is usually done by calculating an equal-weighted or value-weighted average return. This means that that the returns of all the stocks bought or sold by retail traders are weighted equally or by their market cap. But that is not how retail traders invest. They buy more in shares that are attention-grabbing or hyped on social media and in the press and less in “boring” stocks or stocks that are not in the headlines. Unfortunately, the attention-grabbing stocks that retail traders invest more in show large negative abnormal returns in the subsequent days while the boring stocks that they invest less in show positive returns. The result is that retail investors experience negative returns simply by buying too much of the losers and not enough of the winners. And because smaller retail trades are more focused in these attention-grabbing stocks than larger trades, smaller retail investors perform worse than larger retail investors.

This also has important consequences for all the hedge funds and professional investors out there who try to exploit retail trade flows. Because it is typically impossible for these professional investors to buy and sell all the stocks retail investors are trading, they have to focus on a select few. The natural instinct is to focus on those stocks with particularly large flows from retail traders or stocks that are hyped on TikTok, Reddit, and other platforms. And by doing that, these professional investors are setting themselves up to mimic not the abnormal returns in the top chart, but rather the abnormal returns in the bottom chart.