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How Much Protection Do “Mom-and-Pop” Investors Really Need?

What constitutes a retail investor, or an institutional investor?

An institutional investor generally comprises of “whales” – investment banks, mutual funds, insurance companies, and private equity investors, to name a few. According to Investopedia, these investors are responsible for about three-quarters of all trade volume on the New York Stock Exchange alone.

A retail investor, also known as “mom-and-pop” investors, consists of “everyone else”. To simplify things, it would be anyone who does not invest in a professional capacity, such as for a corporation. Retail investors have traditionally being depicted as “gullible” and risk averse. This is in contrast to institutional investors who are seen as much more capable and with the expertise to navigate riskier markets. Institutional investors are thus subjected to lesser oversight from regulators like the Securities and Exchange Commission in the US, or the Monetary Authority of Singapore locally.

Institutional funding has traditionally been the go-to way to raise funds for business. However, securing an investment deal has always been notoriously difficult, and the 2008 financial crisis has not helped. Institutions are tightening their curation processes to prevent a repeat of the saga. Businesses have increasingly turned to alternative financing routes such as crowdfunding, with significant success in their ventures.

Source: BalanceCareers

Crowdfunding and Investments

Crowdfunding is something of an anomaly in the grand scheme of things. Despite the obvious information asymmetry, backers continue to pool their funds for an end product that is not yet complete. This is the case for reward crowdfunding. In donation crowdfunding the implied reward is even less tangible – quite possibly, it’s just a sense of satisfaction. It needs to be noted that most “consumer” platforms e.g. Kickstarter, Indiegogo forbid any form of monetary or equivalent equity rights.

Newer, hybrid models like debt and equity crowdfunding have emerged to fill this gap. These models resemble actual investments, for they promise monetary returns. They are thus subject to regulations and licensing. For instance, in Singapore, these platforms like equity crowdfunding site FundedHere need to register with the Monetary Authority of Singapore (MAS) in order to be allowed to operate in the local market.

The Benefits

The benefits of drawing on the “retail investors” are clear. In this case, you just need to please the very audience you’re trying to get crowdfunding from. This is in contrast to traditional investing models where you need to get investors to agree with you on whether a project has long-term viability, before they will invest. In the case of reward crowdfunding, all the customers are looking for is the reward.

However, the potential of crowdfunding may have yet to be fully realized. In a study on equity crowdfunding it was found that despite the apparent lack of expertise, “naïve investors” – the retail investors in this article – were on average likely to make sound decisions. In fact, their main result was that investors, not sophisticated investors, are required for efficient crowdfunding.Despite having individual informational advantages over naive investors, a crowd of sophisticated investors could not use it. Financing thus breaks down.

For the minority of backers that do fund a bad project such as scams, safeguards such as all-or-nothing mechanisms kick in to return contributions to the backers.

The Limitations

Much has been said about the potential for the crowd to make equally sound decisions as an institutional investor. However, it remains that retail investors are still heavily swayed by their emotions in investing. This manifests in several well-documented behaviours, such as herding, loss aversion, and other psychological biases.

Crowdfunding “fatigue” has also begun to set in, a phenomenon that platforms and businesses alike need to pay attention to. Stung by repeated failures, studies have shown that “early” backers have higher drop-out rates than backers who only fund a project at a later stage. (Source: Understanding Temporal Backing Patterns in Online Crowdfunding Communities by Yiming L.)

Related: Why you flock to crowdfunding projects like sheep

And to top it off – when it comes to funding, the public wallets simply aren’t big enough in comparison to institutions.

The Pareto Principle and Its Importance

For those in the unaware, the Pareto Principle, also known as the 80/20 rule, specifies that 80% of an outcome come from just 20% of a cause. In the case of funding, this means that a minority of the investors can account for a significant funding volume.

Why does this matter? Crowdfunding from the public has helped many a business to start off on a good note. However, the public wallet is simply not wide enough for the long term. This is where institutional investors come in. Remember that investors are now more cautious with what they fund, given that their bottom line is to make a profit. In crowdfunding, other users are drawing onto the signals of early backers to fund the project.

Investors are able to draw on them as a form of validation that a project is more likely to pay off. Indeed, numerous projects such as technology have seen continued investments by big institutions, or even acquisitions in some cases.

Related: Tech projects that beat the odds

Even the otherwise “decentralized” ICO, meant to uproot the “institutional investor” in favour of the crowd, has seen increasing reliance on them. Telegram most notably cancelled the public sale phase of their campaign, after raising $1.7 billion from private investors alone.

Looking Beyond Funding

The crowdfunding market continues to grow, but it is clear from its limitations that it may be approaching a saturation point. How then, can the crowdfunding industry continue to grow?

The solution may lie in its ability to unseat traditional models of business. Where it has once disrupted fundraising, it may be able to do the same for any industry that relies on a community. For instance, in the fields of advertising and marketing. Crowd validation and direct engagement with customers are highly-sought after. Businesses rely on their customers to meet their bottom lines, after all. While funding is no doubt important, businesses should also consider their very core: the everyday customer.

The crowd has always been available to us, right under our noses. Perhaps it is time to start drawing onto the wisdom of the crowd, and harnessing resources beyond just funding.