Half of the losses stem from poor timing of entry, while the other half comes from information asymmetry.
Author: BayFan, BayFamily
Bitcoin and altcoins are surging. The market always goes through peaks and then crashes. However, every time, retail investors lose their money by following a uniform pattern. I recently read a journal paper that described how retail investors lost their money during the boom and bust processes.
The title is 'Wealth Redistribution During the Bubble and Crash Process.'
The historical event on which this paper is based is the 2014 A-share bubble.
During the 18-month period from July 2014 to December 2015, the Chinese stock market experienced a roller-coaster journey: the Shanghai Composite Index rose by over 150% from early July 2014 to the peak of 5166.35 on June 12, 2015 (including a moderate rise from July to October 2014 and a rapid rebound from October 2014 to June 2015), and then crashed by 40% by the end of December 2015.
The author of this paper obtained trading data from all users of the Shanghai and Shenzhen stock exchanges at that time to analyze the reasons why retail investors lose money. Let's start with the conclusion.
The wealthiest households, the top 0.5%, earned over 250 billion RMB, while the bottom 85% of households lost the same amount, approximately 30%. In this process, money was transferred from the pockets of the poor to those of the rich.
This is what people often say: money is transferred from those who need it the most to those who need it the least.
So why does this happen? The main reason is that in the early stage of the bubble, the top 0.5% of large investors increase market risk exposure, while households below 85% do the opposite. In the late stage of the bubble, the middle investors are indecisive about cutting their losses.
Let's first look at the capital inflows. The author categorizes all accounts into three types: household, institutional, and corporate accounts. (Account types and ownership information can be directly observed in our management data. The last category includes cross-holdings by other companies and ownership by government-sponsored entities. Household accounts are further divided into four groups based on account value (defined as the sum of stocks held on the Shanghai and Shenzhen stock exchanges and cash in the account), with cutoff times as follows: below 500k RMB (WG1), 500k to 3 million RMB (WG2), 3 million to 10 million RMB (WG3), and above 10 million RMB (WG4).
Then the author plotted the daily capital inflow for each category against the Shanghai Composite Index on a single chart.
From July 1, 2014, to June 12, 2015, the cumulative inflow of the household sector was 1.1 trillion RMB, while the cumulative inflows of the other two sectors were 80 billion and -130 billion respectively. By June 29, 2015, the household inflow continued to rise, peaking at 1.3 trillion RMB. Shortly thereafter, the household sector began to sell off its stocks to companies, primarily government-sponsored investment vehicles. These government-related entities were instructed by market regulators to 'maintain' the market after one of the most severe crashes in the history of the Chinese stock market. By the end of December 2015, relative to the market peak on June 12, corporate cumulative inflow was 950 billion RMB, while the household sector had a cumulative outflow of 800 billion.
In our bubble crash event, large investors profited while small investors lost. Specifically, from July 2014 to December 2015, due to active trading (i.e., relative to buy-and-hold strategies), the bottom 85% of households lost 250 billion RMB, while the top 0.5% of households gained 254 billion RMB during this 18-month period.
About 100 billion of this wealth redistribution can be attributed to gains and losses from market-level trading. The remaining 150 billion RMB of redistribution results from heterogeneous portfolio choices, that is, differences in stock selection. Large investors may have special information channels.
From these figures, by the end of June 2014, the total holding value of the bottom household group was 880 billion RMB, so the cumulative loss during this 18-month period was equivalent to 28% of their initial stock wealth. Meanwhile, the total holding value of the wealthiest household group at the start of the sample was 808 billion RMB, thus growing by 31%.
There are two reasons why small retail investors lose money.
1. Retail investors, especially the poorest ones, make the biggest mistake of not daring to take risks. In the early bull market, they do not dare to enter with large funds, but instead keep adding funds as the bull market rises. See the chart below. WG1 (the retail investors with the least money) even saw outflows during the early bull market.
2. The medium retail investors are indecisive about cutting losses. Large investors, WG4, quickly and decisively exit after the stock price drops. Small retail investors hesitate, even trying to add funds to bottom-fish.
3. Once retail investors enter the market, they rush into high-risk stocks (High beta), expecting to get rich overnight. They look for cheap stocks. As a result, they end up being trapped.
The paper states these phenomena as follows:
Our analysis shows that in the early stages of the bubble, the largest household accounts, i.e., the top 0.5% of stock wealth distribution, actively increased their market exposure by flowing into the stock market and tilting towards high beta stocks. Then, shortly after the market peaked, they quickly reduced their market exposure. Households below the 85th percentile exhibited completely opposite trading behavior. During this 18-month period, the top 0.5% of households gained over 250 billion RMB, while the bottom 85% lost over 250 billion RMB, or about 30% of the initial account value for any group. In stark contrast, during the two and a half years before June 2014, when the market was relatively calm, the gains and losses experienced by these four wealth groups were an order of magnitude smaller. From the perspective of a systematic investment portfolio selection model, we suggest that this wealth redistribution is unlikely to be driven by investor rebalancing or trend-chasing trading, but rather reflects more the heterogeneity of household investment skills.
During periods of boom and bust, the earnings of the top 0.5% of households far exceed those of the bottom 85%, which is significant for policymakers. It is widely believed that greater participation in the stock market is the path to prosperity and equality, especially in developing countries where financial literacy and market participation are generally low. However, if the poor and less financially mature individuals actively invest in financial markets that are prone to bubbles and crashes, such participation may harm their wealth. This is particularly concerning given recent research that finds that prominent early experiences can have lasting impacts on an individual's economic decisions decades later. Therefore, while more participation in the stock market can enhance welfare, it is important to emphasize that aggressive investing may lead to completely opposite outcomes.
The crypto market is very similar to the early A-share market. Retail investors predominate. The big players call the shots. Carefully reading this paper may help everyone decide on their investments. Half of the losses for small retail investors come from poor timing of entry, and the other half comes from information asymmetry and poor stock selection.
The current market characteristics align very well with the above analysis. A large number of zombie coins defined in March 2024 have been revived.
The altcoin index was rapidly pushed up.
These all show that small retail investors are rushing into the market. Sector rotation often signals that the market is entering the later stages.
Binance has 200 million users, and backend data can actually provide a very clear view of the current market phase. Unfortunately, they will not disclose this data. Only a specific group will benefit.
The conclusion is two sentences.
1. Do not chase high markets. 2. Do not touch altcoins.