During and after the 2008-2009 financial crisis, the media constantly wrote headlines about corruption and scandal on Wall Street. We became familiar with terms such as overleveraged, mortgage-backed securities (MBS), recession, and liquidity crises. We also are reminded of the more recent scandals when we hear names such as Bernie Madoff. Madoff scammed billions from innocent investors by using fictitious financial transactions structured like a Ponzi scheme.
There was, without a doubt, a strong dislike toward Wall Street during those days—especially from Main Street. Many would-be first-time investors in the stock market do not believe it is a fair playing field. Likewise, many market veterans have been burned once too many by the greedy few at the expense of the general population.
So investors rightfully wonder whether the stock market is rigged. Technically, the answer is of course, no, the stock market is not rigged but there are some real disadvantages that you will need to overcome to be successful small investors. Let's examine some of them here which in turn may help you navigate thru future market turmoil.
Key Takeaways
- Stock markets are meant to provide the public with access to efficient and fair financial markets.
- There are some structural issues that tilt trading profits in favor of larger institutional investors, at the expense of less-skilled, less-resourced retail traders.
- Several scandals have also shaken the faith of ordinary investors.
- Despite this, stock markets remain a trustworthy place to invest, especially if you utilize reliable, well-founded strategies such as indexing.
Information Asymmetry
Despite the seemingly endless financial and stock data found online, as an individual investor, you do not have access to in-house technical experts or research analysts. Most investors also do not have sophisticated automated trading systems to provide trading suggestions. Nor are most average investors skilled in technical analysis.
Asymmetric information, also known as "information failure," occurs in a market when one party to a transaction has greater material knowledge than the other party.In markets, insider information can be used to one's advantage, although insider trading is illegal and unethical. Still, professional traders and institutional investors often have an information advantage.
Perhaps an overlooked nuance in this information imbalance is the actual timing or dissemination of information that is crucial. Yes, the internet is somewhat of an equalizing factor, but the reality is that many institutional clients know the outcome of information before the investing public does. Brokerage firms typically have a research department as well as a team of traders.
Access to Capital
Perhaps the biggest disadvantage small investors face is capital. If you aren't familiar with the inner workings of the stock market, imagine you own a small convenience store and want to buy a large order of cigarette lighters for resale. You call up your distributor and ask for a price. On the other hand, Walmart calls this same distributor and says they want cigarette lighters for thousands of stores worldwide. At the end of the day, Walmart has more pricing power than the local store and will get a better price.
Perhaps to a lesser extent, the same is true when buying or selling stock. At the transaction level, similar to Walmart, a larger client will be able to negotiate lower prices on commissions and fees compared to the average investor. In addition, the average investor does not get the same opportunity to subscribe for an IPO that an institution does.
The hot IPOs are generally reserved for the preferred clients: hedge funds and pension funds, and extremely high net worth individuals. Only when all the preferred clients have been offered to subscribe to the IPO would the average investor get a chance to invest. But at this point, you would have to question an investment in an IPO that all the major clients have rejected.
Political Influence
How many individual investors have direct access to elected government officials or have paid lobbyists to look after their interests? Despite the apparent vitriol for financial institutions by the government during the financial crisis, these financial companies still exercise tremendous influence over our political process.
Of course, drug, tobacco, and technology companies also exert political prowess in Washington. Many former government officials end up landing big corporate jobs and vice versa. Most of us do not have a seat at the table when new laws are being considered or written. We rely on our elected officials to do this for us who are the very same people that are influenced by big investors.
Mitigation Strategies
Don't fret, there are ways to work the system or at least raise your awareness of it, but it requires effort. Information, although not always timely enough to matter, is at your disposal. The internet has become an equalizer for the small investor. Financial-based websites can help small investors make heads or tails out of the financial markets. Set aside an hour a week to review business news and trends and read the readily available research reports and profiles.
Furthermore, it is important to keep a watchful eye over your investments and set a stop loss regardless of how much you like the company you own. Many people get wiped out of the stock market because they do not set stop losses on their investments. Of course, many investors use diversified index funds as an investment strategy and are considered to be more "passive" investors. Regardless of your style, monitoring your investments is good risk management.
Some things are not going to be overcome no matter how much homework you do or discipline you display. Huge investment capital and political influence are examples. But one can review publications and align or at least be aware of where institutional money is going. Many publications such as Investor's Business Daily designate institutional sponsorship as a critical investing indicator. Chances are in your favor if you are buying a stock that has a rising institutional presence.
It is also important to realize that markets go up and down and experience what economists refer to as exogenous shocks. These are events that no one, including the privileged few, could have predicted.
The Bottom Line
The stock market is technically not rigged against the average investor. Laws and governing bodies exist to level the playing field for everyday investors. The role of the Securities and Exchange Commission is to protect investors and maintain fair, orderly, and efficient markets.
However, there are undeniable advantages Wall Street money managers have over us, such as timely access to privileged information, huge amounts of capital, political influence, and greater experience. Nevertheless, these apparent disadvantages should not dissuade you from reaching your investment goals.
By carefully monitoring your investments and taking risk mitigation steps such as setting stop losses, as well as keeping informed of general investment themes or trends, you can overcome these imbalances and still be successful in your investing.
Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circ*mstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal.
