Dramatic trading in GameStop, AMC, and other “meme stocks” has reignited debates about the efficiency of the stock market, its purposes, and whose interests it should serve. The changing role of retail investors and meme investors, a subset of retail investors involved in recent stock rallies fueled by social media, has raised urgent questions around the need for regulatory agencies to protect them.
In a recent article, I discuss the evolving role of retail investors in price discovery and the stock market. Calls for regulation usually misunderstand the role of retail investors, either dismissing them as victims of suspect trading practices or, more recently, vilifying them as perpetrators of market instability. Both conceptions oversimplify. They fail to consider nuanced and important ways that retail trading is increasingly able to affect stock prices. Specifically, recent meme investing has revealed the important but underappreciated way in which today’s retail investors interact with and affect stock prices.
Understanding this relationship is crucial in evaluating responses to recent trading episodes. My analysis reveals that the influx of retail investors – either intentionally or unintentionally coordinated in their trading[1] – has introduced an overlooked form of risk to other market participants, which I call “coordinated retail risk.” Coordinated retail risk arises from the growing potential for retail trades to affect or predict future price movements. This risk exists irrespective of the actual information content of retail trades. That is, the likelihood that a single retail trade contains fundamental information about future stock prices may not have changed. Yet, the likelihood that many coordinated retail trades will predict or affect future prices has increased.
A few factors have driven this change. Today’s retail trades are increasingly sticky, or more likely to affect or predict future price movements, irrespective of their information content. This is because today’s retail traders are more numerous and coordinated, and have more direct market access, than ever and use new, low-cost trading technology that promotes social aspects of trading.
By some accounts, retail trading volume has reached that of mutual funds and hedge funds combined, growing from roughly 15–18 percent of all trades in early 2020 to 30 percent of all trades by early 2021. The market capitalization of some small-cap stocks was 25 percent higher as a result of retail trading. Retail traders now own upwards of 80 percent of the stock of AMC and more than 30 percent of Tesla. Companies such as Costco or Apple also see significant retail ownership: Retail investors own 30 percent of Costco and 41 percent of Apple.
Low-cost coordination, usually through social media or social trading platforms, has spurred retail trading power. Social media has substantially expanded retail investors’ access to, and dramatically lowered their costs of acquiring information through investing sites ranging from SeekingAlpha.com to Reddit.com. Investors join online communities and trade for a sense of camaraderie, as well as to take part in social movements. Retail trading platforms promote social, coordinated trading, while significantly lowering its costs, even encouraging retail investors to copy each other’s portfolios. Cognitive biases and phenomena such as herding, which have been known for decades to affect investing decisions of all traders, have also been exacerbated, amplifying price impact. These insights are important because retail trading has traditionally been thought to have little effect on prices, markets, or the behavior of other traders. Even less attention has been paid to the consequences for market structure of impactful retail trading.
The effect of coordinated retail risk on stock prices and the mechanisms of market efficiency can be understood by dividing retail investors into three categories: coordinated uninformed retail investors, coordinated informed retail investors, and coordinated meme investors. Evaluation of responses by other market participants demonstrates that coordinated retail risk, by itself, reduces the incidence of socially beneficial fundamental informed trading by reducing its expected profitability. Informed traders may engage in fewer trades that seek to benefit from fundamental information about the underlying issuer because they anticipate losses or smaller gains caused by retail trades. This is especially true if retail price impact proves less sensitive to corrective trades by informed traders, sustaining longer periods of mispricing. Crucially, informed traders will have less incentive to generate new information about an issuer that is not yet reflected in price. A lower level of robust information-generation will reduce price accuracy and weaken market mechanisms that further optimal capital allocation over the long run.
Coordinated retail risk can also reduce liquidity by contributing to wider bid-ask spreads. This is because liquidity suppliers (those who intermediate trades by buying from traders wishing to sell and selling to traders wishing to buy) anticipate greater losses to retail traders whose trades predict future price movements, irrespective of those trades’ actual information content. If not countered by the overall injection of liquidity provided by retail investors, costs of trading increase for all market participants.
The potential implications of coordinated retail investing are wide-ranging. More sustained episodes of mispricing may occur. A fear of short-term losses has already reduced the number of short sellers who are willing to bet against meme stocks (and even some stocks popular with retail investors more broadly, such as Tesla), especially when retail motivations are not sensitive to changes in information about the underlying issuer. Coordinated retail risk also affects the mechanisms by which stock prices help allocate resources in the economy. Stock prices play a critical role in corporate governance, for example, by acting as a proxy for information about a company and its investment projects and signaling market reactions to its governance and management. Coordinated retail investors also affect stock prices that are keyed to, for example, shareholder litigation and index fund composition. Securities class actions depend on the fraud-on-the-market theory that assumes that stocks trade in an efficient market where public information about an issuer affects its stock price. Appraisal actions that evaluate the fair value of a security during mergers and acquisitions also depend on stock prices. A company’s ability to raise capital is also tied to its stock price. Indices such as the Russell 1000, 2000, or 3000 that contain meme stocks may see dramatic swings in valuation, creating costly implications for funds and investments with billions of dollars pegged to those indices. Opportunities may also arise for impact investing by retail investors, and retail investors may increasingly play larger roles in shareholder governance.
To be clear, my article does not posit that retail trading will topple markets. Retail trading may significantly benefit market functioning in some ways, and retail access to and participation in markets benefit society. Moreover, pockets of inefficiency, or irrational pricing, have always existed – caused just as much by sophisticated investors as unsophisticated. And noise is an inevitable part of markets. Instead, the article focuses on whether and how retail trading affects stock prices, the overlooked risks it adds to the complex market ecosystem, and potential consequences for efficiency. Whether today’s retail trading ultimately helps or hurts the mechanisms of market efficiency depends on the type and amount of retail trading. It also depends on whether any negative effects caused by coordinated retail risk are counterbalanced by other benefits, including those from increased retail participation in the stock market.
A number of goals should therefore guide policy responses: improving information relied on by retail investors, enhancing retail investors’ participation in shareholder governance, and improving broker incentives as well as trading platform design. These broad goals are not new. Yet for the same reasons that retail investors’ impact on prices has largely been overlooked, securities laws have focused insufficiently on retail-specific aspects of disclosure, such as the information that actually reaches retail investors and drives their trading decisions. For example, to the extent that social media or social trading networks drive retail trading and are even displacing the role of traditional sell-side analyses, it is crucial to encourage better social media analyses. If deployed productively, social media and new trading platforms can play a substantial role in funneling good information to retail investors, expanding the retail investor base, and even addressing broader fairness concerns. Greater retail participation in shareholder governance may also increase retail informativeness. A feedback loop would enhance the effect, as increased retail participation could lead to more information-sharing by companies, which would tend to make retail participants more informed and more likely to participate. Facilitating retail voting and encouraging more informed investor participation could have additional benefits, from increasing financial literacy to improving perceptions of market fairness and access. It is also important to consider the role of brokers as well as trading platforms. Financial literacy remains an important goal, and any reforms that target retail investors’ ability to trade or participate in the markets must account for those investors’ responses to any such policy changes. To that end, it makes little sense to impede frictionless trading. Nor does it make sense to limit retail participation in markets in any significant way.
Ultimately, while coordinated retail risk can distort stock prices, greater retail participation can also benefit markets by enhancing retail engagement in corporate governance and markets. The way forward, then, should focus on encouraging more informed retail participation.
ENDNOTES
[1] References throughout to “coordinated” trading include both unintentional coordination, such as that which occurs through herding, as well as intentional coordination, for example, coordination through social media.
This post comes to us from Professor Sue S. Guan at Santa Clara University School of Law. It is based on her recent article, “Meme Investors and Retail Risk,” available here.