You probably already have a sense of what an investor is. If you’ve ever purchased a stock, mutual fund, exchange-traded fund (ETF), or any other security, you’re an investor.
Investors come in all shapes and sizes - young and old, wealthy and modest, sophisticated and novice. In today’s digital world, you can open and fund a brokerage account on your phone without ever speaking to another person. Even teenagers, who have historically been less interested in investing, are now commonly putting money in the stock market through modern platforms like Robinhood.
Generally speaking, investors are categorized into one of the following:
Retail investors are non-professional individual investors. This includes you and me.
Although most securities investors are retail investors (in terms of number of people, not trading volume), many retail investors are unsophisticated (meaning they lack significant financial knowledge) and may misunderstand how markets work.
The short squeeze of Gamestop (GME) stock is a useful example. Some smaller investors made significant profits as GME rose from roughly $20 per share in early January 2021 to roughly $480 per share later that month. However, many investors bought shares in the $200-$400 range and then watched the price fall back to about $50 by mid-February 2021.
As quoted in this New York Times article:
" At its highest point, GameStop’s share price was $483. On Friday [February 5th, 2021], the stock was worth $63.77. The trading frenzy - powered by online hype over a rebellion against traditional Wall Street powers - had created, and then destroyed, roughly $30 billion in on-paper wealth.
Many small-time investors who got caught up in the mania as it peaked lost big. Timing a trade perfectly is nearly impossible even for the best stock pickers, so even those who made money missed out on far greater riches if they didn’t sell at the rally’s peak."
The GME short squeeze was unusual and emotionally charged, but it still illustrates a broader point: retail investors can lose significant amounts of money, especially when trading is driven by hype and rapid price swings.
Whether regulators take action to prevent a similar situation is uncertain (as of this writing in May 2021), but it’s reasonable to expect some legal updates.
Securities regulators (like the state administrator and the Securities and Exchange Commission (SEC), which we’ll discuss later) focus heavily on protecting retail investors.
As you work through the Laws & regulations unit, keep track of:
A common pattern is that supervision and regulation are more extensive when retail investors are involved, while more exceptions apply when dealing with larger institutional investors (discussed next).
An institutional investor is a single entity that invests a pool of capital (money). Common examples include:
In each case, a large pool of capital is managed by a financial professional (often a team). You won’t need to memorize the operational details of each type, but a little context helps.
Mutual funds
As we learned previously, mutual funds are portfolios made up of shareholder funds and managed by an industry professional.
For example, the Fidelity Contrafund is a fund with over $100 billion in assets, managed by Will Danoff. Mr. Danoff is Ivy League educated (Harvard and Wharton School of Business) and has managed the fund for over 30 years. He and his team invest this portfolio on behalf of customers in return for customer fees (somewhere around $100 million annually).
While the Contrafund is a stock-based fund with moderate risk, there are thousands of mutual funds available (7,945 mutual funds existed in 2019). Each fund has its own risks, benefits, and goals. For investors who don’t have the time or knowledge to manage their own portfolios, mutual funds can be a practical option.
Hedge funds
Hedge funds are similar to mutual funds, but they’re generally available only to wealthier investors. They pool capital and often invest aggressively in pursuit of higher returns.
Hedge funds received significant media attention during the Gamestop (GME) short squeeze in 2021 because some funds with large short positions (essentially betting against Gamestop) lost billions of dollars.
Pension funds
Pensions were once a common employee benefit. A pension is a retirement plan offered by an employer that promises lifelong payments to retired employees who meet certain qualifications.
For example, an employer might promise to pay retired employees 70% of their highest annual earnings after 20 years of employment. If an employee’s highest annual earnings were $100,000, the employer would owe $70,000 per year (often with a cost-of-living increase) for the rest of the employee’s life.
While pension plans vary in structure and benefits, they share a key challenge: making sure the plan doesn’t run out of money (an unfunded pension liability). Employers contribute significant amounts each year, but life expectancies have risen over time. The longer retirees live, the more money the pension fund needs to meet its obligations.
That’s why many employers hire financial professionals to manage and invest pension assets. If the pension fund grows, the employer may be able to contribute less in future years.
Today, pensions are rare in the corporate world, largely due to the rise of the 401(k). However, government employers (local and federal) still commonly offer pensions.
Banks & credit unions
Depository financial institutions like banks and credit unions allow customers to keep money on deposit. These institutions earn profits by using a portion of deposited funds in ways that generate returns.
Most commonly, they lend customer deposits to individuals and businesses and earn interest. Banks and credit unions can also invest funds in the securities markets. Larger banks may invest millions or billions of dollars, although federal regulations limit how much bank deposit money can be invested in aggressive securities like stocks. These institutions typically place educated and experienced professionals in charge of these investments.
Insurance companies
Insurance companies also invest company money (largely from insurance premiums) and customer funds in the securities markets.
Because insurers must be able to pay claims, they generally keep significant capital available and often invest large portions in safer, short-term securities (e.g., money markets like Treasury bills). Many insurance products (e.g., annuities) also include features that require investing in the securities markets, including the stock market.
As with the other institutional examples, insurance companies rely on financial professionals to manage these pooled investments.
Investment advisers
Investment advisers are firms that provide advice on securities or manage client assets (we’ll cover the legal definition of an investment adviser in a future chapter).
Many advisers use omnibus accounts, which combine client assets into a single account. This lets the adviser trade as a single entity on behalf of clients and can provide leverage in the markets (you don’t need the mechanics here). The key idea is that a professional is investing a pool of money on behalf of others.
Some retail investors are educated and understand market dynamics, but many do not. Because retail investors often have fewer resources (capital, knowledge, experience, market data, legal expertise, and so on), they’re typically at a disadvantage when dealing with financial professionals and large investors (like institutions). That’s a major reason securities laws and regulations prioritize retail investor protection. When a retail investor works with a financial professional, some form of government supervision is usually involved.
Institutional investors, by contrast, are generally sophisticated and professionally managed, with substantial resources and market leverage. As a result, securities laws often include exceptions to normal rules and protocols when professionals deal with institutional investors, which can mean less government supervision. Institutional investors don’t receive the same protections retail investors do - but they’re also investing large pools of professionally managed assets, supported by significant resources.
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