‘Dumb money’ is fueling one of the biggest lies on Wall Street, researcher says

“Nobody likes to be average.”

That idea is reinforcing “one of the big lies from Wall Street” as retail investors turn to platforms such as Robinhood to try their hands at stock-picking, Larry Swedroe, chief research officer at Buckingham Wealth Partners and co-author of “The Incredible Shrinking Alpha,” told CNBC’s “ETF Edge” on Monday.

The rush of retail traders to the stock market during this year’s volatility has romanticized stock-picking in a potentially dangerous way, said Swedroe, whose latest book is just out in its second edition.

“That’s what Wall Street tells you — we could do better than average — which of course is possible to do,” Swedroe said. “But the fact is that’s one of the big lies from Wall Street.”

“We know that if you just passively invest in these index funds, you get market returns, which means you outperform or get higher than average returns than the vast majority of active investors,” he said.

Over the long term, that tends to hold true. Most active managers underperform the S&P 500 over the intermediate and long term, with 92% of large-cap funds underperforming the passive index over the last 15 years, according to S&P Dow Jones Indices.

The few who outperform usually have a technological edge over other active managers and the ability to “exploit” the small-but-growing community of retail investors that some on Wall Street have labeled dumb money for their lack of experience, Swedroe said.

“They’re exploiting the ‘dumb’ Robinhood investors. That’s where their edge is,” he said. “They’re not generally trying to pick stocks, time the market. They’re trying to exploit mostly micro-inefficiencies, which they’re able to do.”

One way to curb that exploitation could be to levy “a very small transactions tax” on those firms “and use that to fund the SEC and make it a stronger, better organization,” he said.

The most important thing for individual investors to remember is not to take on too much risk, Swedroe said.

“You can be highly involved in the markets without being on Robinhood and day trading,” he said. “If you really want to keep it very simple, you can basically own a Vanguard Total Stock Market Fund for the U.S., a Vanguard Total International Fund and own a Treasury bond or, better even yet, build your own portfolio of [certificates of deposit], and that’s all you need.”

As for the Robinhood traders, they need to ask themselves a few key questions anytime they decide to buy a stock, Swedroe said.

“Who’s on the other side of the trade that’s selling that stock to me?” he said. “Since we know 90% of the trading is done by big institutions, they’ll likely have far more information [than] me, so, why am I buying when they’re selling?”

“If they don’t have an edge over these big institutions, they’re likely playing the losers’ game, which they should stop playing unless it’s purely entertainment like we go to the casinos in Vegas,” he said.

Entertainment is, in a way, one of the key elements of this market, Dave Nadig, chief investment officer and director of research at ETF Trends, said in the same “ETF Edge” interview.

“The reality is if we were all just buying the Russell 3000 and then forgetting about it for a year, we would get rid of an entire source of entertainment,” Nadig said. “For many people, it’s not just about earning money. It’s a hobby.”

While there’s nothing inherently wrong with trying your hand at the market, it’s imperative to understand the risks involved, the CIO said.

“Don’t have the assumption that you’re somehow going to do better than a passive portfolio because the math is just not with you,” Nadig said. “It doesn’t make it wrong. It just means it’s non-economic.”

Nick Colas, the co-founder of DataTrek Research, said in the same interview that retail traders tend to pave the way for bigger firms when it comes to emerging capital markets.

“I’m not uncomfortable with the idea that everything begins as retail and then moves to institutional,” Colas said. “As far as the Robinhood money being dumb money, I’m kind of careful on that notion because for years we complained that retail investors weren’t getting involved in the stock market. The percentage of U.S. households that owned stock was declining. And then here we have a sudden flare-up of people actually being interested in the stock market, and we can’t have it both ways.”

Perhaps Wall Street is underestimating Robinhood traders. Many of them famously nailed the market bottom in March, and the start-up reported more daily average revenue trades in June than all of the other major brokerages.

“Either you want people involved in the market, engaged in capitalism and understanding how this thing works, or you want them out,” Colas said. “I personally think it is a good thing that Robinhood traders are coming into the market because even if some blow up — and some certainly will — you still have more people interested in the capital markets and that is net-net a good thing, not a bad thing.”