How Retail Investors Get the short end (and How to Fix it)
Individual investors are the invisible backbone of the investing economy.
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Individual investors are the invisible backbone of the investing economy.
If the investment world were an iceberg:
- Investment bankers, hedge fund managers, and other such untrustables would be the tip of the iceberg—the part that the public sees.
- Retail investors would be the vast majority of distributed wealth supporting the investment economy in the shadows, unseen.
This divide isn’t accidental. It’s a result of systemic flaws in traditional financial systems. These systems favor large, affluent investors who have more influence, access, and information than individual investors. Those “tip of the iceberg” investors can take advantage of high-quality investment opportunities that are out of reach for most people.
Why and how are the best investment opportunities reserved for the tip of the iceberg?
Let’s dig under the surface and find out.
It all starts with
Where’s Your Pension?
One of the most common ways individual investors get screwed over is by relying on retirement fund systems that have proven to be unreliable, expensive, and limited.
Pensions, for example, have become increasingly rare in the US private sector. In fact, only about 25% of civilian workers have access to one. Instead, employers have shifted to defined contribution plans, such as 401(k)s. Rather than relying on a public treasury, these plans require workers to contribute their own money and bear the investment risk.
In exchange, an employer might offer a miniscule 3-5% match.
These plans are supposed to help workers save for retirement by allowing them to defer taxes on their contributions until they withdraw them. However, many 401(k) plans have high fees and commissions that eat away at the returns.
Not to mention the investment options in most 401(k)s are limited, and don’t fit the risk profile for most sophisticated retail investors.
When you add in all the complex regulations around retirement funds, and you get the result we have today: workers who cheer the fact that their employer matches a miniscule 5% of their contributions, not realizing what they’re missing out on.
Bearing the Cost of Poor Management
Another way individual investors get screwed over is by having little or no control over their investments, then paying fees to fund managers who often do worse than the market.
In a 5 year study of 2,132 mutual funds, not a single actively managed fund outperformed an unmanaged index fund. Not. One.
This raises the question:
Why do individual investors pay high fees and commissions to fund managers who actually make less money than an unmanaged fund?
One possible answer: individual investors are unaware of the impact of fees on their long-term returns. For mutual funds, these fees come in the form of an “expense ratio” that acts as payment for managing the fund.
It’s a tiny-looking percentage that adds up to massive losses over time.
For example, if your mutual fund has an expense ratio of 1%, it means the fund deducts 1% of its assets every year to cover its costs.
So if an investor invests $10,000 in a fund that has an annual return of 10% before fees and an expense ratio of 1% (which are realistic numbers), after 20 years, the investor would have:
$49,725
However, if the same investor started with the same amount, got the same returns, and had an expense ratio of 0.1% (which is realistic for an unmanaged fund), the investor would have:
$60,949
That’s a difference of more than $11,000 due to fees alone. In other ways, management fees are a scam.
So why do individual investors keep paying these fees?
Unfortunately, because we’ve been tricked by some clever marketing tactics.
Never Trust a Suit
Never trust anyone in a suit. Suits are uncomfortable, unnatural, and completely absurd abominations of the professional world. They should be abolished.
Yet, you’ll never see more suits in any industry than you do in financial management.
That should tell you something…
Financial institutions use clever tactics—far more sophisticated than suit-wearing—to manipulate the world’s perceptions of them.
Even their fund names and appearances project security. Wealth. Stability.
- Vanguard
- Morningstar
- Blackrock
- And so on
These tactics have been used for over a century, and include projecting a facade of trustworthiness through formal attire, using jargon and technical terms to confuse or impress investors, or creating artificial scarcity or urgency to induce fear or greed.
Bernie Madoff was the king of this. He orchestrated the largest Ponzi scheme in history ($65 billion). To pull it off, he wore bespoke suits and cultivated an aura of exclusivity and secrecy around his hedge fund.
He claimed he had a proprietary trading strategy that could generate consistent returns of about 10% per year. However, he was actually fabricating statements and using money from new clients to pay off old ones.
The lesson: if management fees can be deceiving, the people who charge them are even more deceptive.
Minimum Investments
Most individual investors can’t even get access to the best investment opportunities.
Why? Because hedge funds and private equity funds often have minimum investment thresholds, many of which are $1 million or more.
In other words, individual investors who want to get higher returns by investing in startups and other hidden gems can’t even get their foot in the door.
So they’re left to put money in a 401(k), mutual fund, or some other money pit with miniscule returns and unnecessary risks.
The Status Quo No Mo’
Individual investors who want to achieve:
- Higher returns
- Lower fees
- And more flexibility
—should consider investing in startups, not mutual funds.
Unlike the traditional financial system, which often screws over individual investors with minimum investments, management fees, and limited access, investing in startups offers many advantages.
Retail investors can invest any amount they want, pay no fees or commissions, access the highest returns, and diversify their portfolio. They can also help fund startups that are solving real problems and creating positive impact in the world, and enjoy the thrill of being part of something new.
Investing in startups is not without risks, but it can also offer great rewards for those who are willing to take the leap.
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