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Why retail investors have been ‘very good for markets,’ according to a finance professor

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Jan-Oliver Strych, Karlsruhe Institute of Technology Assistant Professor of Finance, joins Yahoo Finance Live to discuss study results indicating the positive impact meme stock and retail investors have had on the market.

Video Transcript

[MUSIC PLAYING]

- All right, the rise of the retail investor this year has been a good thing for markets says our next guest. Jan-Oliver Strych is an investor, is an assistant professor at the Karlsruhe Institute of Technology, and joins us now.

Good to see you this morning. Really enjoyed your research. What was your conclusion? Has the retail investor been good for markets?

JAN-OLIVER STRYCH: Yeah, thanks for having me here. Yeah, I think retail investors are very good for markets. In academic literature a long time ago, a lot of studies said they are uninformed, they are overconfident. But I think more recent research shows that they are informed, in fact.

And we actually deal with the idea that retail investors mitigate crash risks in stocks. And we saw that in times of the pandemic. We used that as an exogenous shock so to have best practice research here, and to make sure that our results are holding.

And what we saw is that in times of stress, of turmoil, market turmoil, we see that retail investors provide liquidity to institutional investors that are forced to sell to do fire sales in this stressful situation. And by doing so, they actually decrease the crashes, the impact of crashes during the pandemic.

- Jan-Oliver Strych, as you said, this is contrary to sort of conventional wisdom here. Right? That it's institutional investors that provide stability in the market. Were you surprised by the findings? And how were you able to tell the role that retail investors were playing here?

JAN-OLIVER STRYCH: Yeah. So actually for me, it was not surprising as institutional investors. Because as you know, regulation do force them to sell whenever there is a stressful situation. And we saw that in March 2020 very clearly, that all institutional investors sold at the same time, driven by regulation, and driven by withdrawals.

There was a dry out in money markets. So actually this is called arbitrage capital that is missing, even if there is arbitrage out there. Then retail investors can step in. Because they are self-financed and they get some checks from the governments, they got it directly.

So they were able to step in and actually buy those very cheap stocks that were very cheap because of fire sales. And so that is actually some kind of explanation here. And that is more severe or stronger if we have this kind of liquidity shock driven by the pandemic.

- You know, one thing that stood out to me that you wrote about. You say governments should motivate more retail investors to invest in financial markets. What does that mean? Do you think the government should be handing out $5 checks to go invest in stocks? Talk us through it.

JAN-OLIVER STRYCH: Yeah, maybe via taxation. So actually they can for example motivate to do more stock investments by better taxation, lower taxation on those. In Germany, where I'm coming from, we have a different taxation as in the US. So in the US, we know that retail investors are very prevalent. So it's not so in European markets. So actually this kind of motivation should be more for European. I think in the US, where we do our study, we see actually that retail investors are investing at huge masses.

So I think government can also do more on financial education. It's very important that retail investors get equipped with the right knowledge, with the right skills. Even though it's very easy for them to do the transactions very, very cheap, in a cheap manner, but you need some knowledge. And this is very important.

Our study does some analysis on this as well. So actually, our study does not say that retail investors actually are informed. We can't say something about that at that stage.

But what we can do is, or what we can find here in our study is that retail investors are rational. And that is a surprising finding as well because a lot of studies before thought that retail investors are irrational traders that could be exploited by institutional investors. Yes, it is true. But we also saw that those investors that mitigate the crashes here in our study, they invest actually in stocks that are less volatile, less solid, and less liquid.

So we conclude here that it's important for retail investors to invest only in stocks, they are advantaged, they're disadvantaged in a way. Their information is lower in comparison to institutional investors. And that is actually where for example a stock is not so heavily shorted, because then it is very unlikely that they are counterparty, and the trade is better informed. And that is actually some kind of recommendation for retail investors here, to be very cautious in selecting the stocks you invest.

- All of this is really interesting because I think retail investors have been saying, don't underestimate us. We know what we're talking about. And this actually puts a little bit of academic scholarship around that and behind it. In your research though, are there any sort of negatives that you did find from retail investor involvement, or risks associated with it?

JAN-OLIVER STRYCH: Yeah, we didn't look at that specifically, I have to admit. We did actually look at the characteristic of certain stocks. And we found that the crash risk is not impacted by retail investors if for example the stock is very shorted. So actually, only for some set of stocks, this average effect we found out in the first place is valid.

And that's very important academic research. If you're old, you have to be very cautious in interpreting it because they are average effects. And that's why we looked at these specific stocks.

And as I said for example if you take a stock like Tesla, like just an example, that is heavily shorted in the pandemic, it was. And now, it's not so shorted anymore. But at that time, you can see that the liquidity and the crash risk is not mitigated, or is not higher because it's a shorted stock.

If you take for example Ford, Ford is very heavily invested by retail investors. And actually, this stock has some kind of positive effect on liquidity and crash risk. It is lower, definitely, in the times of the pandemic. And this is actually interesting. So it's important to know about the right stocks to select.

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