Institutional investors are investment banks, insurance companies, mutual funds, pension funds and hedge funds. Retail investors are individuals with brokerage accounts. The significance of institutional investment as a predictor of equity performance is widely debated. It's more generally agreed that retail investors significantly underperform the market. Trading volume is the clearest indication of investor sentiment by these two groups.
Institutional Buying as a Predictor of Stock Performance
Professional stock market analysts and economists divide into two groups. The first group believes that certain informed investors -- such as the managers of investment funds -- have the skills to outperform the market. Commentators and analysts for "Investors Business Daily," a widely read financial daily newspaper, fall into this group. Writing in "IBD," Alan R. Elliot notes that one of the most important factors when evaluating a stock is its institutional support. Purchasing stocks with a pattern of strong and increasing institutional buying, in this view, is a winning investment strategy.
Keeping the Playing Field Level
Another group of financial experts disagrees. Proponents of the "efficient market hypothesis" assert that, except for insider trading, which is a federal offense, the market results of institutional investors are no better than chance. With a large population of institutional investors, they note, some can outperform the market for a while, but over longer periods, their performances revert to the mean. From this perspective, you may do no worse than average buying stocks being accumulated by institutions, but in the long run you'll do no better.
A Modified View of Efficient Markets
Two leading economists, Eugene Fama and Kenneth French, compiled extensive data on the performance of institutional investors. They noted that in a few instances the performances of certain managers did not revert to the mean -- that is, did not worsen over time until their overall results were only average. If you buy the stocks these institutional investors are accumulating in their portfolios, you can outperform the market. But they pointed out a catch: The statistics of chance are such that quite a few institutional investors will outperform the market for a time, and almost all of them will then underperform the market. Only a very few will continue to outperform the market -- possibly one out of a hundred. How do you identify that one superior investor? After the fact, it's easy. Earlier, it may not be possible.
Agreement on Underperformance
If buying stocks with increasing purchase volume by institutional investors is a debated strategy for stock market investment, buying stocks with increasing purchase volume by retail investors is not. Increasing data and analysis indicate that individual investors underperform the market by selling winning equities and buying losing equities. As economist Brad Barber concludes in a September 2011 paper on investor sentiment, retail investors repeat past trading behaviors that coincided with pleasure and avoid behaviors that generated pain, regardless of the inapplicability of these behaviors to present market realities. This suggests that increasing retail purchase volume may even be contra-indicative and a signal to sell.
- University of Massachusetts: The Behavior of Individual Investors
- Luck Versus Skill in the Cross-Section of Mutual Fund Returns: Eugene F. Fama and Kenneth R. French
- National Bureau of Economic Research: The "CAPS" Prediction System and Stock Market Returns
- Investors: Learn to Read Institutional Buying
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