Back The Bros Against The Hedgies

“Bros” connecting through the social media forum “WallStreetBets” last week staged a massive rally in the shares of GameStop (NYSE: GME) causing huge losses to a hedge fund that had shorted the stock. Most commentary suggested this should be a rare occurrence, as the hedge fund was a professional investor performing a valuable market function, while the Bros were amateur retail investors. However, in today’s markets, I would bet on amateur investor Bros showing better investment performance than the hedge funds.

The investment management industry is keen to highlight the fairly dubious statistics that show that retail investors underperform “professional” investors over the long-term (and that both underperform the market, a statistic that I have never entirely understood). There are three reasons why for many retail investors this would be the case. First, there are many crooks about in the investment business who prey on retail investors, particularly older and richer ones – this in itself produces underperformance. Second, retail investors who use a financial advisor, as many do, are not getting the cream of the crop (unless they are themselves extremely rich, with a Private Office). Most advisors in the retail investment business would rather be advising institutions, because that’s where the money is, and you don’t have to sell so hard; hence with admirable exceptions, the average retail advisor is an underperformer.

Third, and most difficult to get round (and this one applies to the Bros also, who don’t have advisors) most retail investors put new money into the market when it is bullish and exciting, and withdraw money from the market at the bottom, because they get depressed. Needless to say, this is fatal to investment returns.

So how can I claim that the Bros will generally outperform hedge funds?

You have to look at the economic cause of hedge funds’ proliferation, and at the incentive structure within them. Bros, by and large, are risking their own money. They have no mechanism to fund-raise and hence are focused solely on maximizing investment return. Their one weakness is a tendency towards “irrational enthusiasm” in bull markets, taking larger risks when the market is more overvalued and pulling back when it is low, especially in a period of prolonged undervaluation like the late 1970s.

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(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of "sell" recommendations put ...

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