Why Individual Investors Lose: A 2025 Journal of Finance Study Explains

A 2025 study published in the Journal of Financial Economics analyzed how nine different categories of market participants trade relative to 193 market predictors. The finding for retail investors was unambiguous: individual investors systematically trade in the wrong direction. Not occasionally. Not in specific market conditions. Systematically, on average, across the broadest investigation of market participation ever conducted.

The research, “Taking Sides on Return Predictability,” was authored by R. David McLean of Georgetown University, Jeffrey Pontiff of Boston College, and Christopher Reilly of the University of Texas at Dallas. Using data covering retail investors, institutional investors, hedge funds, corporations, and short sellers, the study identified who actually makes money in the stock market and who does not. The results challenge assumptions that millions of retail investors are making right now, often in real time, on apps designed to make trading feel effortless.

What the Study Actually Found

The researchers built a comprehensive forecasted-return variable based on 193 stock return predictors drawn from decades of academic research. These predictors include signals related to valuation, momentum, profitability, growth, and dozens of other factors that have historically forecast which stocks will outperform or underperform going forward. They then compared these forecasts to the actual trading behavior of each investor category.

The results sorted market participants into clear groups.

The smart money: Corporations conducting share buybacks and short sellers. Both of these groups traded in the direction that the forecasted-return variable predicted. Companies that buy back their own stock have an informational advantage that no analyst or retail investor can match: they know their own business, their own cash flows, and their own valuation better than anyone. Short sellers, who profit when stocks decline, are among the most sophisticated participants in any market and do substantial fundamental research before taking positions. Both groups consistently positioned themselves on the profitable side of the market’s predictable patterns.

The neutral money: Institutional investors, including mutual funds, pension funds, and notably, even hedge funds’ long equity positions, showed no robust ability to position on the right side of predicted returns. Institutional investors as a group accumulated more stocks with low expected returns than high expected returns, contributing to the very anomalies they might be expected to exploit.

The losing side: Retail investors. The study found that individual investors accumulate stocks that end up being anomaly shorts, meaning they buy the stocks that the academic evidence most strongly predicts will underperform. They simultaneously reduce holdings in the stocks most likely to outperform. Their aggregate trading predicts returns in the opposite of the intended direction.

The researchers also found that the forecasted-return variable predicts returns most strongly precisely in the stocks where retail trading is most intense. Put simply: the more individual investors pile into a stock, the more likely it is to underperform the market. High retail enthusiasm is, on average, a negative signal.

Why This Happens

The study does not document malice or irrationality in retail investors specifically. It documents predictable behavioral patterns that produce systematically poor outcomes, patterns that behavioral finance researchers have been documenting for decades.

Individual investors tend to chase recent returns: buying stocks that have recently done well and selling those that have recently done poorly. Research going back to Barber and Odean’s foundational work in the early 2000s has consistently shown that retail investors buy high and sell low, not because they intend to, but because recent performance is the most visible and emotionally compelling signal available. When a stock has climbed 40% over the past year, it feels like confirmation of quality. When a stock has dropped 30%, it feels like confirmation of failure. Both intuitions are frequently wrong as predictors of future returns.

Retail investors also exhibit what researchers call the disposition effect: a strong tendency to sell stocks that are currently in a gain position, locking in the profit-related emotion of winning, while holding stocks that are currently at a loss, avoiding the emotion of realizing a loss. This pattern means individual investors systematically cut their winners too early and hold their losers too long, the opposite of what evidence-based investing recommends.

Finally, retail investors tend to concentrate their attention on high-profile, heavily discussed stocks: companies in the news, recent IPOs, stocks trending on social media and financial apps. These are almost always the stocks where valuations already reflect the most optimism, leaving the least room for further outperformance.

Even Hedge Funds Are Not the Answer

One of the more striking findings in the McLean, Pontiff, and Reilly study is the underperformance of institutional investors, including hedge funds, on the long side of their equity portfolios. Hedge funds are known for sophisticated research, quantitative models, access to management teams, and enormous resources. And yet the study found that hedge funds’ long equity positions were poorly positioned relative to the 193-predictor forecasted return variable, failing to predict positive returns in the intended direction.

Hedge funds are significantly better at short selling than at long investing. Their advantage is most concentrated in identifying stocks to short, not stocks to own. For the retail investor considering whether to delegate stock selection to an actively managed fund in the hope that professional managers will do better, this data is sobering: the category of professional investors most associated with sophisticated stock research does not demonstrate consistent skill at selecting long-term winners.

This finding is consistent with decades of mutual fund performance research showing that actively managed equity funds, on average, underperform their benchmark index after accounting for fees. The McLean study adds nuance: even the most sophisticated institutional investors, not just average mutual fund managers, struggle to position their long equity portfolios on the right side of predicted returns.

The Cost of Being on the Wrong Side

Being a retail investor who systematically trades against predicted returns is not merely a neutral outcome. It has a compounding cost. When individual investors buy stocks with low expected returns and sell stocks with high expected returns, they generate transaction costs on both sides of each trade. They also pay taxes on capital gains when they sell winning positions early. And over time, the return gap between a systematically poorly positioned portfolio and a diversified market index portfolio compounds into a substantial dollar difference.

The gap between low-cost index fund investing and active stock picking involves two separate costs: the behavioral cost of making systematically wrong selections, and the structural cost of higher fees on any actively managed vehicle. The calculator below shows what fee differences alone do to a portfolio over time, before accounting for the additional performance drag from poor stock selection.

What the Smart Money Does That You Can Replicate

The study’s finding that corporations executing share buybacks are among the most reliably positioned market participants offers one practical signal for individual investors: pay attention to insider buying and corporate repurchase programs as signals of management’s actual conviction about valuation. When insiders buy their own company’s stock with their own money, and when boards authorize significant share repurchases, this represents the most information-rich signal available, because the buyers have the most complete information.

But the broader implication of the research is simpler and more immediately actionable: the case for passive index fund investing is not just about lower fees. It is about opting out of a behavioral game that the evidence shows most participants lose. An index fund does not make decisions about which stocks to buy. It does not chase recent performance. It does not exhibit a disposition effect. It does not get excited about the stocks everyone is talking about. It simply holds the market, proportionally, and captures whatever return the market delivers.

The McLean, Pontiff, and Reilly study shows that the market’s predictable return patterns persist most strongly precisely where retail investors concentrate their attention and trading. The implication is that retail investors, by trading actively, are not just failing to earn market returns, but are actively contributing to the conditions that make those patterns persist. Individual investor enthusiasm amplifies the mispricing that more sophisticated participants exploit.

The Practical Implication

The research does not suggest that all individual investors always lose or that no one can successfully pick stocks. A small minority of investors do demonstrate persistent skill. But the study’s aggregate finding is clear: as a group, retail investors trade in the direction that predicts losses. The stocks they buy underperform. The stocks they sell outperform. This pattern is robust across the broadest dataset ever assembled on market participation.

For the millennial or Gen Z investor who opened a brokerage account in the past few years, possibly attracted by zero-commission trading apps and social media stock discussion, the research offers a direct answer to the question of whether active stock selection is likely to add value: on average, it does not. It subtracts value relative to a passive alternative.

The alternative is straightforward. Low-cost, diversified index funds or ETFs tracking broad market benchmarks have minimum expense ratios, eliminate the behavioral decision-making that the research shows destroys value, and over long time horizons have outperformed the majority of actively managed alternatives. The boring option, holding the whole market and doing nothing, is supported by the most comprehensive study of market participation published in 2025.

The smart money knows what it owns and why. The research shows that, for most retail investors most of the time, that means knowing they do not know which stocks will outperform, and investing accordingly.