The Different Types of Investors

Overview

In a preceding article, the definition of an investment operation was presented and analyzed. While the definition of investing is more or less universal, the same cannot be said for “investor”.

An investor doesn’t necessarily have to be a person: universities, trust funds, and other legal entities are considered “investors”, even though they are not persons.

Not only that, but investors fall into different categories, which usually depend on their level of financial knowledge, whether they invest for themselves or on behalf of others, their net worth, and their legal designation (i.e., are they a person, a corporation, a private business, etc.)

In this article, we will focus on three types of investors: retail, institutional, and accredited. We will look at the definitions presented by the U.S Securities and Exchange Commission (SEC), then break those definitions down into simpler terms.

Retail Investors

The SEC defines retail investors as¹:

“a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family, or household purposes”.

Put plainly, a retail investor is an everyday person who manages their personal investment portfolio or the investment portfolio of their family.

Retail investors are usually classified as “non-sophisticated” by regulatory bodies such as the SEC.

This means that retail investors usually do not possess the investing skill to manage the investments of others in a professional capacity (this is what institutional investors do), nor do they have the skill or capital needed to purchase exotic asset classes (accredited investors are assumed to have the necessary capital and knowledge to purchase such investments).

A retail investor is usually characterized as an entity that purchases a relatively small quantity of investments (i.e., only purchases a small number of shares or bonds), trades investment products using a brokerage, and generally exerts very little influence on investment markets (if they were to sell all their shares of a particular company, the stock price wouldn’t change dramatically, if at all).

Because retail investors are classified as non-sophisticated, this places a limit on what sort of investments they can make.

For example, retail investors are usually prohibited from investing in private enterprises (i.e., businesses not listed on any sort of financial exchange) unless they satisfy certain net worth and net income requirements, as well as have the approval of a regulative body.

A criticism of the definition for a retail investor is that it implies that a person of lesser means (that is, has a lower net worth or possesses fewer assets) is immediately less financially savvy than someone who has a higher net worth or has more assets².

It’s not unheard of for a person to inherit their assets or to simply get lucky on a speculative purchase they made, so having a high net worth does not automatically make a person a more capable investor.

Institutional Investors

The SEC provides a very holistic definition of what an institutional investor is³. Please note that the SEC definition of an institutional investor has the stipulation “includes, but is not limited to”:

“(i) a manager of investment accounts on behalf of other than natural persons who, with affiliates, exercises sole investment discretion with respect to such accounts, provided there are more than 10 such accounts having a fair market value of not less than $10,000,000.

(ii) investment companies, universities, and other organizations whose primary purpose is to invest its own assets or those held in trust by it for others.

(iii) trust accounts and individual or group retirement accounts in which a bank, trust company, insurance company, or savings and loan institution acts in a fiduciary capacity.

(iv) foundations and endowment funds exempt from taxation under the Internal Revenue Code of 1986, a principal business function of which is to invest funds to produce income in order to carry out the purpose of the foundation or fund.”

Despite the exhaustive definition presented by the SEC, an institutional investor can simply be thought of as a person or legal entity that invests on behalf of other people or other legal entities.

Mutual funds are a classic example of an institutional investor: people contribute money to a mutual fund, and a fund manager(or managers) decides which investments to purchase on behalf of their clients.

Unlike retail investors, institutional investors are categorized as “sophisticated”. That is, they can make investments that are otherwise unavailable to the retail investor, and are recognized as having the skills and knowledge to manage other people’s portfolios in a professional capacity.

Institutional investors are also known for purchasing much larger quantities of securities than retail investors, usually tens of thousands, hundreds of thousands, or even millions at once.

Instead of purchasing millions of individual securities, institutional investors instead purchase something called “blocks”. A block refers to a large order of the same security (stocks, bonds, ETFs, etc) and is frequently purchased by institutional or other large investors.

Because institutional investors invest on behalf of others, they are bound by certain regulatory requirements⁴, such as what securities they are and aren’t allowed to purchase.

Some investors such as Warren Buffett and Benjamin Graham warn people not to be impressed by the titles of “institutional” or “sophisticated”. Just because people give their money to a fund manager does not guarantee superior returns.

To prove this point, between 2007 – 2017, Warren Buffett made a bet with Tom Seides from Protégé Partners that, on a basis of net fees, a low-cost index fund will outperform a basket of carefully selected hedge funds. Warren Buffett ended up winning the bet, with his low-cost index fund sporting a compounded 7.1% annual return, whereas Mr. Seides’ funds had a compounded annual return of 2.2%.

Accredited Investors

The definition given by the SEC for accredited investors is extremely comprehensive; you can find the full definition here:

When talking about people (in legal terms known as a “natural person”), the SEC categorizes them as accredited investors if they satisfy at least one of the following criteria:

• Have a net income more than $200,000 USD, or $300,000 USD when combined with a spouse in the past two calendar years, with the expectation that the same income will be earned in the current year.
• Have a net worth greater than $1 million USD (either individually or combined with a spouse), excluding your primary residence.

As you can see, receiving the designation of “accredited investor” is no easy task. Minimum standards of income or net worth must be satisfied before someone can call themselves an accredited investor.

However, this makes a lot of sense: the investments available to accredited investors present a much higher risk of loss than the investments available to retail investors, namely private equity and unregistered securities.

An individual seeking to make private investments or purchase unregistered securities should have sufficient assets to make up for any potential losses, which could prove to be far in excess of what a retail investor can handle.

Wrapping Up

Although the definition of investing is by and large unchanging, not all investors are created equal. Investors usually fall into one of three major classifications.

Each classification of investors is afforded certain rights in terms of what they are and are not allowed to put their money into.

An investor should understand what classification they fall under, lest they want to purchase an investment product they legally are not allowed to purchase or land themselves a very expensive lawsuit.

Sources