(Bloomberg Opinion) -- Shoppers heading to their local mall to buy socks would generally buy fewer of them if they found that prices had, say, doubled. Investors are the opposite of shoppers. They tend to get excited by higher prices for financial assets. If prices of stocks double, it is likely that investors will want them more. And the more they go up, the more investors tend to want them in a phenomenon known as “fear or missing out,” or “FOMO” for short.
That’s why measuring investor sentiment is so crucial. Analysts have built sentiment indicators for a wide range of financial assets, not just for stocks. Lots of Wall Street types don’t like them because they’re not an exact science, but it has always been my belief that sentiment analysis works better at predicting future market moves than either technical analysis or fundamental analysis. Probably the best-known is the survey conducted by the American Association of Individual Investors. And although it is flawed, it still works at the extremes.
There are many ways to track sentiment. It can be measured over the short, medium or long term, or by investor class. What’s interesting is that when the stock market was collapsing in December, measures of sentiment among “fast money” folks like hedge funds and active traders fell to apocalyptic levels. Retail investors, though, seemed unfazed, as a net $22 billion flowed into passive index funds during the quarter, according to data compiled by Bloomberg.
This is strange! Retail investors have a reputation for always being wrong, buying high and selling low. That’s why they are called the “dumb money.” This time around, the large parts of the stock market goes into what is considered to be the technical definition of a bear market, which is a decline of 20 percent, and retail investors are steadfastly bullish.
Today’s retail investor looks different from the 2001 retail investor that got killed when the dot-com bubble burst. Instead of day trading stocks in a discount brokerage account, they have morphed into long-term index fund investors. All the behavioral coaching by index promoters over the last 10 years, urging retail investors to invest passively with an eye on the long run while minimizing costs, seems to have worked — but at what cost?
Ordinary, fallible, all-too-human investors without a lot of financial knowledge or historical perspective are being conditioned to keep investing through major declines in stock prices. Historically, there was a penalty imposed (in terms of returns) on the unsophisticated and the uninformed. Today, the unsophisticated and uninformed are outperforming the professionals. These days, it’s retail investors who are tough, and institutional investors who cut and run at the first sign of trouble.
This is all a bit upside-down. Are retail investors getting smarter? Are sophisticated investors getting dumber? The answer to both questions might be yes, but both are cartoonish extremes of the same issue. Institutional investors — particularly hedge funds — could benefit from a longer-term outlook, which they might be able to achieve if they were able to obtain five- to 10-year lockups from their investors. Having to provide monthly or quarterly liquidity forces many hedge funds to stick to index-hugging investments that can be easily sold in the event of redemptions.
Meanwhile, retail investors could benefit from some framework of risk management, even simple stop losses, instead of having a childlike view that stocks will go up forever, monotonically. The hardiness of index fund investors might seem like an asset during a 20 percent decline, but a liability during a 60 percent decline or any bear market from which the market might not fully recover. Retail investors are taught by every guru, every website, every book and every Twitter personality that the stock market “always comes back.” But what if, one day, it doesn’t?
Yes, recent history has shown that professional investors have had great difficulty outperforming passive indexes. Retail investors beating up on the hapless hedge fund industry makes for good tweets, but we should all ask whether it is sustainable. Some 25 years ago, the top hedge funds were making triple-digit returns and retail investors weren’t making much at all. Fast forward to today, where it has been a real disadvantage to be smart. It’s not a disadvantage to be smart in too many other industries, so forgive me for believing that the current state of affairs might be transitory.