One of the deepest mysteries related to the ongoing rally in U.S. equities is the persistent lack of retail investor involvement. QAs we have vociferously noted, U.S. equity mutual fund flows remain solidly negative and interest in single stock trading among individual investors is similarly moribund - while corporate bond volumes remain flat and Treasury volumes higher. As Nick Colas, of ConvergEx group, notes, one missing link to explain this dichotomy must be the fundamental lack of financial literacy among U.S. retail investors, yet this relationship is seldom mentioned as a reason for this group’s ongoing apathy in the face of 4-year highs for domestic stocks. The Securities and Exchange Commission’s recently released study of financial literacy among retail investors outlines just how little this group really knows about capital markets and highlights the underlying rationale behind many of their recent seemingly irrational behaviors.
Stock vs Corporate Bond vs Treasury trading volumes...
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Nick Colas, ConvergEx: Retail Investors And Financial Literacy
If the U.S. equity market is such a good party, why is the dance floor so empty? OK – that’s a bit of exaggeration, of course. At the same time, it is hard to overlook declining volumes in stock trading or the persistent redemptions out of U.S. equity mutual funds. A few points here:
- The S&P 500 is up 14.3% year-to-date, but the funds dedicated to this asset class have yet to see a month where money flows are positive.
- Over this year of above-trend performance, in fact, investors have redeemed just over $80 billion in assets from U.S. stock mutual funds, or $250 for every American man, woman and child.
- Look further back, and this pattern hold true for the entire rally from the lows in March 2009. American investors aren’t chasing performance; in fact, they are running from it.
- A recent article on Bloomberg cited a 37% drop in trading volume on U.S. exchanges when comparing the first half of 2008 to the same period in 2012. The August comparison, using data we compile at ConvergEx, shows that trading volumes for last month were down more like 45% from the same month in 2011.
While there are a host of reasons for the decline in U.S. volumes, the issue I would like to focus for the remainder of this note is retail investor knowledge and how this relates to their confidence in capital markets. The connection between these two factors is straightforward: investors need more than a rising market to invest. They need to feel that they understand it and enjoy some level of competence before they trade. An academic paper, published in Management Science (Investor Competence, Trading Frequency, and Home Bias by Graham, Harvey and Huang, July 2009) performed a useful analysis defining this relationship. A few points to summarize their work:
- Using data from surveys conducted by UBS/Gallup, the researchers ranked retail investors by how “Competent” these market participants rated themselves at making their own investment decisions on a 1-5 scale.
- Investors who ranked themselves as significantly more competent traded (4 or more on that 1-5 scale) much more frequently than those who ranked themselves lower. Over half of this group traded at least once a month, versus 28% for the lower-ranked group, for example.
- The research also established that men trade much more than women, with 43% trading once a month, versus just 25% for their female counterparts. Relative youth also correlated with greater trading frequency, as did the level of household income.
- Levels of educational achievement also correlate strongly with the frequency of trading. A retail investor with a post-graduate degree trades stocks on a monthly basis much more frequently than one who did not finish college – 43% of the first group trades monthly, versus just 25% of the latter.
That last point, on education, got me wondering about how much U.S. retail investors really understand about modern capital markets. As it happens, the U.S. Congress had a similar question in the wake of the Financial Crisis and asked the Securities and Exchange Commission to explore the topic as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Their study, released on August 30th, leverages a review of various literature on the topic done by the Library of Congress as well as the SEC’s own findings from focus groups and online surveys of retail investors.
The upshot of these analyses is bleak: “The studies demonstrate that investors have a weak grasp of elementary financial concepts and lack critical knowledge of ways to avoid investment fraud.” Much of the +200 page SEC review is not actually about financial literacy, but rather describes how investors process information regarding financial disclosures in the face of this knowledge deficit. The numerous direct quotes from survey and focus group respondents highlights that investors want simple, brief disclosures and explanations, despite their lack of understanding of how capital markets work.
The Library of Congress report, published in December 2011, contains even more chilling details about what U.S. investors actually know about capital markets. The study, which reviews 8 different independent surveys, starts with a key finding of a 2009 FINRA report that “Americans lack basic financial literacy.” The report includes the questions posed by the different surveys, a sample of which I include here, along with a few observations:
- Question: If interest rates rise, what will typically happen to bond prices? Only 21% of the 2009 FINRA National Financial Capability Study knew that the answer was “They will fall.” The same question to a group of active U.S. military got only a 30% correct response rate. In a 2010 Northwest Mutual survey, only 41% knew the relationship between interest rates and bond prices. This may go part of the way to explaining why fixed income products - mutual funds and exchange traded funds, not to mention individual bonds – still enjoy strong money flows despite record low interest rates. What happens to retail investor confidence in these investments when interest rates rise is, therefore, impossible to know.
- Question: Buying a single company’s stock usually provides a safer return than a stock mutual fund? Only 52% of respondents in the 2009 FINRA survey got this right, and a 2007 Moneytrak/IPT survey found that only 39% of respondents knew the definition of “Diversification.”
- Question: What return would you expect from a broadly diversified U.S. stock mutual fund over the long term? The “Correct” answer, according an SEC telephone survey held in 2008, is 10% and 53% of respondents answered as such. Numerous other studies had similar questions about the long run potential of U.S. stocks and most respondents answered in the same vein.
Two points pop out from this line of questioning. The first is that none of the surveys asked “How much volatility are you willing to stand in order to earn that 10%?” That’s a critical variable, and it may well be that retail investors are anchoring their expectations of future volatility against the last 5 years. Second, it might be the case that investors have downgraded their expectations of long-term returns with the paltry returns exhibited by stocks since 2000.
In summary, the data shows that retail investors do not generally have the knowledge necessary to make sense of modern capital markets. Add the volatility of the Financial Crisis and the macro-policy driven stock markets of today, and you have a recipe for reduced confidence in their abilities to invest. Against that backdrop, the asset moves out of stocks and into bonds makes sense.
You might argue that “It was always thus…” and that is a fair point. American investors haven’t grown dumber on financial matters in the last decade; they never had the requisite knowledge to begin with. But it does appear that the events of the last few years have caused some kind of “Tipping point” with regard to investors’ ability to process the world around them. The only prescription to allay their concerns is, I think, time. Time, and continued strong performance from U.S. stocks.