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, experienced and brand new. 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 historically haven’t been very active in investing, are now commonly putting money in the stock market through platforms like Robinhood.
Generally speaking, investors are categorized into one of the following:
Retail investors are non-professional individual investors. This category includes you and me.
Most securities investors are retail investors by headcount (even though retail investors don’t account for most trading volume). Many retail investors are also relatively unsophisticated - meaning they don’t have significant financial knowledge - and they 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 a high of 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 substantial amounts of money, especially when trading is driven by hype and rapid price swings. Whether regulators will take action to prevent a similar situation is unclear (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, pay attention to:
A common pattern is that supervision and regulation increase when retail investors are involved, while more exceptions apply when dealing with larger institutional investors (covered 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 don’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 and is 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).
The Contrafund is a stock-based fund with moderate risk, but there are thousands of mutual funds available (7,945 mutual funds existed in 2019). Each mutual 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 a lot of 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 annual cost-of-living increases) for the rest of the employee’s life.
While pension plans vary in structure and benefits, they share a core challenge: making sure the plan doesn’t run out of money (an unfunded pension liability). Employers contribute to pension funds each year, but life expectancies have risen over time. The longer retirees live, the more capital 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 through investment returns, 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, many government employers (local and federal) still offer pensions.
Banks & credit unions
Depository financial institutions like banks and credit unions allow customers to keep money with them. These institutions earn profits by taking a portion of deposited funds and investing it.
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 rely on highly educated and experienced professionals to manage those investments.
Insurance companies
Insurance companies also invest company money (mostly from insurance premiums) and, in some cases, customer funds in the securities markets.
Because insurance companies must be able to pay claims, they generally keep substantial capital available and often invest large portions in safer, short-term securities (e.g. money markets like Treasury bills). Some 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 use financial professionals to manage these pooled investments.
Investment advisers
Investment advisers are firms that provide advice on securities or manage assets for clients (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 don’t. Because retail investors often have fewer resources - capital, experience, market data, and legal expertise - they’re typically at a disadvantage when dealing with financial professionals and large investors (like institutions). That’s why securities laws and regulations prioritize protecting retail investors. When a retail investor works with a financial professional, there’s almost always some form of government supervision.
Institutional investors, by contrast, are generally sophisticated and have significant market leverage. Securities laws often include exceptions to standard rules when professionals deal with institutional investors, which can mean less government supervision. Institutional investors don’t receive the same protections retail investors do, largely because they represent large pools of professionally managed assets and the professionals overseeing those funds have access to substantial resources.
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