The era of the retail investor

In Western democracies, a crisis has been simmering beneath the surface for the past decade. Social movements have risen up against what they define as global capitalism. In parallel with the French Revolution in the end of the 18th century, small retail investors have had enough of their oppressive financial dictators, the hedge funds. The individuals is rising to change the order structure of finance, aiming for decentralization of the incumbent industry.

A retail investor is a non-professional investor, contrary to the institutional investors of Wall Street. The impact of retail investors in the market has increased dramatically in recent years.

During the last decade, capital has flown disproportionately from hedge funds to passive funds and individual management by retail investors. Today, passive funds account for more than 25% of all US fund assets, up from under 10% in 2000. The same trend is seen with individual investors. According to Bloomberg, individual investors accounted for nearly 20% in 2020 compared to just 10% in 2010. These trends are two pieces of a much bigger jigsaw puzzle: the era of the retail investor.

Distrust towards hedge funds and banks has risen after the financial crisis. Many believe that the severity of the financial crisis can be attributed to the creation of mortgage-backed securities by banks and hedge funds. Whether that is true or not is disputed within the academic literature. What is not disputed is that this discourse has dominated the media and resentment has grown amongst groups of the population.

Before the financial crisis, society witnessed the privatization of profits and, after the crisis, the socialization of losses. In the aftermath of the financial crisis, banks were bailed out, and the losses were billed to the taxpayer. Over the last decade, several key factors have led to the rise of retail investors in the market.

Three tailwinds have made the era of the retail investor possible:

Technological advances
The longest bull market in history
Digital communities.

Technological advances

The technological progress and adoption of the internet and smartphones have not only connected people worldwide. It has disrupted financial markets by making information more readily available and connecting more buyers with sellers. Potential investors have increased as technology has made financial instruments more available through apps and user-friendly websites. Robinhood, an American investment platform, has played an important role in the new era of the retail investor. They have shown that investor communities, not institutions, can drive security pricing. Robinhood became a household brand during the pandemic as it armed retail investors with the necessary financial instruments to rebel against the big hedge funds. They played a major role in the GameStop frenzy at the start of 2021. More on that later.

The pandemic itself did not bring new trends into the world of finance and investing. Instead, it speeded up trends that existed beforehand. During the pandemic, a large influx of younger investors entered the markets as society closed because of restrictions. People went from working in an office to working remotely from their homes. The population was handed stimulus checks by the government, while lockdowns kept people inside. Many younger people were drawn into trading with securities to enhance their financial situation. The newly arrived investors took more speculative and risky bets and traded more frequently. Many times, with leverage and in concentrated positions.

The longest bull market in history

The longest recorded bull run in more than 160 years was the bull run that started in March 2009 and lasted until the pandemic hit the world in 2020. An 11-year bull run where the S&P500 generated 330% returns. Only two other bull markets have lasted longer than seven years: the 10-year bull run in the 1990s and the post WW2 bull run that started in 1949. The bull market of the 2010s gave investors a strong incentive to enter the market and at times gave the sense that the party would never stop. One of the factors behind the expansion from 2009 was the FED’s dovish monetary policy consisting of low-interest rates to stimulate the expansion of business. The bull market gave incentive to new investor to enter the market as no interest was given to their savings accounts, and capital for that reason was placed in the stock market. As capital from retail investors entered the market, their influence grew.

Digital communities

The great flood of new, mostly young investors, unsurprisingly turned to digital communities to discuss investments. And where do young people create communities today? On social media platforms like Reddit, Twitter, etc. Communities like the notorious WallStreetBets on Reddit experienced a big flood of new dedicated members. At the time of writing, WallStreetBets has over 11 million members, or as they call themselves “degenerates”. The term “meme stock” was coined and attributed to stocks such as GameStop and AMC. A meme stock is a company whose shares explode when they're popularized on social media platforms like Reddit. They are often not based on fundamentals and are considered risky investments as they rely heavily on small investors to sustain stock prices.

Studies show that individual investors in the digital communities typically have small account sizes and cannot move the market by themselves. But the digital communities concentrated the community’s investments and a combination of easy money, low-interest rates, and new retail investors resulted in the pumping of several “meme stocks”. This is not to say that the new reality is to invest in meme stocks, but rather that individual investors can move the market to a much greater extent than previously seen.

The GameStop Saga

The rising influence of individual investors in the market came to light in early 2021. A combination of costless data and costless trading mixed with strong digital communities resulted in a cocktail that Wall Street had not tasted before. I present you with the GameStop saga. A David and Goliath tale of the weak retail investors versus the strong billion-dollar hedge funds on Wall Street. A story that cements that we have entered the era of the retail investor.

GameStop is a video game chain, which has more than 5.000 stores. At GameStop, customers can buy, trade, and sell their video games. Many people attribute strong nostalgia to the brand GameStop, as they in their younger days have come there to buy video games. When the pandemic struck the world, GameStop shares plummeted to an all-time low of $2 to $4. This was largely due to lockdowns forcing stores to close and earnings to fall. The company was close to the brink of disaster, and big hedge funds on Wall Street saw an opportunity. An opportunity to bet against the company with large short positions to profit from its downfall.

How does short-selling work?

Short sellers are betting against a company by borrowing shares from brokers and selling it on the market, in the hope of buying them back when the stock price is lower, pocketing the difference. Short sellers must buy back the shares and return them to the lender at an agreed upon time. Having a short position carries unlimited risk of losses, because there is not a limit to how high a stock can rise.

The rare phenomenon of a short squeeze can occur when the price of a very shorted stock rises, forcing the short sellers to buy back the stock, which pushes the stock price even higher. This was exactly what happened with the GameStop stock. A short squeeze that costed hedge funds $12,5 billion over the course of January in 2021. Actually, the stock was not just heavily shorted. The stock had a 140% short interest at peak, meaning that more shares were shorted than the company had outstanding.

The primary motive for both parties was an opportunity to make money. For the WallStreetBets community to make a quick buck trading an undervalued stock. For the hedge funds to capitalize on a failing business and profit off the ignorant young investors. Behind the scenes, the investment thesis for the WallStreetBets community changed to a battle against the establishment. A battle against the big, powerful hedge funds. The American philosopher Eric Hoffer once said: “mass movements can rise and spread without belief in a god, but never without a belief in a devil”. The hedge funds became the villain, the devil and as the narrative grew, the conviction and long positions became bigger.

The final countdown

Melvin Capital, a hedge fund betting against GameStop, became the face of Wall Street. They had a very substantial short position against GameStop at the start of 2021. The GameStop stock went from around $20 at the start of 2021 and peaked at $350 market close on January 27th. That is an increase of over 1700%. Contributing factors to the rise in price did not only restrict to the WallStreetBets community. Elon Musk jokingly tweeted “Gamestonk” on January 26th, encouraging people to invest. Furthermore, Chamath Palihapitiya, a venture capitalist, tweeted that he was buying GameStop calls. Digital communities on both Twitter and Reddit were blowing up, and the short and long side almost became religious in their beliefs.

On January 27th the atmosphere was electrifying. David, the retail investor, had defeated Goliath, the hedge fund Melvin Capital. Melvin Capital had to close its short position and lost 36% of its assets under management. That was a loss of $4,5 billion. Eventually, Melvin Capital had to be bailed out by two other investment companies, Citadel and Point72, to avoid bankruptcy. In the weeks following GameStop’s peak at $350 the stock price crashed to around $40. Today, one year later, it sits at around $120, considerably higher than the $20 before the frenzy occurred.

The GameStop saga shows how powerful retail investors have become. Under the right circumstances, retail investors can move stock prices. A phenomenon previously only attributed to hedge funds and banks. In a way, communities like WallStreetBets are the new hedge funds. They are decentralized and have been able to amass as much capital as big hedge funds. The era of the retail investors was made possible by the advances in technology, digital communities, and the longest bull run in history fuelled by easy-money policy.

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