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A 2025 study in the Journal of Financial Economics offers a useful explanation for why retail investors can underperform when picking individual stocks.
In Taking Sides on Return Predictability, researchers R. David McLean, Jeffrey Pontiff, and Christopher Reilly compared the trading behavior of nine groups of market participants with a forecasted-return measure built from 193 previously documented stock-return predictors.
The result was striking: retail investors tended to buy stocks with lower forecasted returns and sell stocks with higher forecasted returns. Their aggregate trades also predicted subsequent returns in the opposite direction from the study’s return signal. Firms and short sellers showed the opposite pattern.
That does not mean retail investors always lose, that the 193 predictors perfectly forecast returns, or that one study proves everyone should buy index funds.
The more useful conclusion is narrower: individual stock selection is difficult, and retail investors as a group appear to make decisions that can work against them.
For someone without a demonstrated stock-picking edge, reducing the number of individual-stock decisions you have to get right may be a feature, not a limitation.
Key takeaways
- Retail trading leaned against forecasted returns. Individuals tended to buy stocks with relatively lower forecasted returns and sell those with relatively higher forecasted returns.
- Firms and short sellers were better aligned with the signal. The authors describe these groups as tending to behave like “smart money.”
- Professional status did not guarantee superior positioning. Institutional trades also predicted returns opposite to the intended direction in the final paper’s aggregate findings.
- The study does not test index funds against stock pickers. Any case for passive investing requires separate evidence.
- Low-cost index funds can reduce stock-selection decisions, but they still carry market risk and are not automatically the right investment for every goal.
What did the 2025 study actually test?
Taking Sides on Return Predictability was published in Volume 173 of the Journal of Financial Economics in November 2025.
The researchers combined 193 return predictors into one comprehensive forecasted-return measure.
These predictors come from the large academic literature examining characteristics that have historically been associated with differences in future stock returns.
The study then compared that forecast with how nine categories of market participants changed their positions.
The basic question was:
When the return predictors pointed toward relatively higher or lower expected returns, which investors tended to trade in the same direction?
That is different from asking whether every trade made money.
A stock classified as having a higher forecasted return can still fall. A stock with a lower forecasted return can still rise.
The study deals with expected and subsequent returns across large samples, not certainty about what any particular stock will do.
That distinction matters because describing the findings as investors simply buying “future losers” and selling “future winners” makes the research sound much more deterministic than it is.
What did the study find about retail investors?
This is the strongest part of the paper.
Retail investors traded against the forecasted-return measure.
The authors found that retail investors tended to buy stocks with lower forecasted returns and sell stocks with higher forecasted returns. Retail trading also predicted subsequent returns opposite to the intended direction of the return signal.
The poor positioning was not explained only by a narrow set of average stocks. The paper reports that it was driven by trading among stocks at both the high and low ends of the forecasted-return distribution.
The researchers found something else interesting.
Their return forecast worked more strongly in stocks experiencing more intense retail trading, a result they describe as consistent with retail investors exacerbating mispricing.
But be careful with how you interpret that.
It does not mean:
“If retail investors like a stock, short it.”
Nor does it establish that every popular stock will underperform.
It is an aggregate relationship across a large dataset, not a trading rule for individual companies.
Why might retail investors make worse trades?
The 2025 paper establishes the trading pattern more clearly than it establishes a single psychological cause.
So I would separate the two.
What the paper shows: retail investors traded against the study’s return signal.
What may help explain it: earlier behavioral-finance research has documented tendencies such as attention-driven stock selection, frequent trading, performance chasing, and reluctance to realize losses.
Those mechanisms are plausible explanations, but they are not interchangeable with the result of this paper.
That distinction is important for two reasons.
First, not every retail investor behaves the same way.
Second, telling yourself that you understand common biases does not automatically make you immune to them.
You can know what performance chasing is and still buy a stock after watching it double.
Are firms and short sellers really the “smart money”?
The authors use that description because firms and short sellers tended to trade in the direction implied by forecasted returns, and their trades predicted returns in the intended direction.
But this result is easy to overinterpret.
It does not mean you should copy corporate buybacks
The study examines firm trading in the company’s own equity.
That includes broader corporate equity activity and should not be simplified into:
“A company announced a buyback, therefore the stock is undervalued.”
A repurchase can happen for many reasons, and an announcement does not automatically tell you whether the stock is attractive at today’s price.
The study finds an aggregate relationship between firm transactions and forecasted returns.
It does not publish a retail investing strategy that says to buy every stock undergoing a repurchase.
It does not mean short selling is easy
Short sellers were well positioned in the study, but that does not make short selling an obvious strategy for ordinary investors.
Short selling introduces risks that long-only investors do not face, including potentially very large losses if the stock rises.
The practical lesson from the paper is not to imitate whichever participant group performed best.
Doing that would simply replace one stock-selection strategy with another.
What did the study find about institutional investors?
This result makes the paper more interesting than a simple “professionals beat amateurs” story.
The final paper reports that retail and institutional trades predicted returns opposite to the intended direction, while firms and short sellers were the two groups with clearer positive positioning relative to the forecast.
An earlier working-paper version divided institutions into six categories and similarly found no robust return-predictive trading advantage across those institutional groups.
That does not mean every institution or fund manager lacks skill.
Aggregate results can coexist with highly skilled individual managers.
The harder problem for an investor is identifying those managers before their future performance is known.
Does active fund performance tell the same story?
It tells a related story, but this is separate evidence.
The McLean, Pontiff, and Reilly paper does not compare an actively managed mutual fund with the S&P 500.
For that question, SPIVA data are more relevant.
S&P Dow Jones Indices reported that 78.78% of active U.S. large-cap funds underperformed the S&P 500 in 2025. Over the 10 years ending December 31, 2025, the underperformance rate was 85.59%.
One year should not be treated as a law of investing. There are periods and fund categories where active managers perform better.
For example, only 41% of active U.S. small-cap funds underperformed their benchmark in 2025, meaning a majority outperformed that year.
That nuance matters.
The evidence is not:
“Active management never works.”
It is:
Sustained benchmark outperformance has historically been difficult for a large share of active funds, particularly over longer horizons.
That is a much stronger and more defensible reason to be skeptical of claims that beating the market is easy.
Does the study prove index funds are better?
No.
This is probably the most important correction to the original argument.
Taking Sides on Return Predictability studies how different market participants trade relative to expected returns.
It does not compare:
Stock picker A vs. index fund B
and measure which one produces the better lifetime outcome.
So index investing is my practical inference from the evidence, not the paper’s direct conclusion.
The argument goes like this:
- Retail stock trades were poorly positioned relative to a broad return-prediction measure.
- Consistently outperforming benchmarks is difficult even among many professional active funds.
- Index funds allow investors to own a portfolio without repeatedly deciding which individual stocks will outperform.
- Passive management often involves less trading and can have lower costs, although not every index fund is inexpensive.
That makes a broad, low-cost index strategy reasonable to consider for a long-term investor who does not have a demonstrated stock-picking edge.
It does not make index funds risk-free or universally superior.
What an index fund actually solves
An index fund does not make behavioral risk disappear.
You can still buy after the market rises, panic-sell during a crash, constantly switch funds, or choose an unsuitable portfolio.
What it does remove is one particular decision:
Which individual stock should I own next?
Traditional index funds seek to track a specified market index rather than asking a manager or investor to continually choose securities expected to outperform.
For someone tempted to jump between whatever companies are currently receiving the most attention, that can be valuable.
A broad index approach also makes diversification easier than building a portfolio around a handful of individual stocks.
But “index fund” does not automatically mean “well diversified.”
A fund tracking a narrow technology, industry, thematic, or other specialized index can still be highly concentrated.
Look at what the fund actually owns, not just whether the word “index” appears in its name.
Why costs matter
Stock-selection skill has to overcome costs before it adds value to your portfolio.
For investment funds, those costs include management fees and other expenses.
Investor.gov notes that passive index funds may have lower costs because they generally require less active security selection and trading, while also warning that not every index fund costs less than an actively managed fund.
The arithmetic itself is straightforward.
If two investments generate identical gross performance, the one taking less in fees leaves more of that return with you.
Investment Fee Impact Calculator
That does not mean you should simply choose the cheapest fund you can find.
Compare:
- What index it tracks
- What assets it owns
- Expense ratio
- Diversification
- Tracking quality
- Trading costs
- Whether the fund fits your investment goal
Cost matters, but the wrong portfolio does not become the right portfolio simply because it is cheap.
What are the risks of index funds?
Index investing is sometimes described so positively that beginners can mistake passive for safe.
It is not.
Investor.gov notes that index funds face the risks of the securities in the index they track. They can also experience tracking error and may underperform the index because of fees, expenses, or trading costs.
A broad stock-market index can fall significantly.
If you invest money you will need soon, diversification does not guarantee that the money will be available at the value you expect when you need it.
That is why the decision should not begin with:
“Index fund or individual stock?”
It should begin with:
“What is this money for, when will I need it, and how much risk can I afford to take?”
Only then does choosing the investment make sense.
Should you stop picking individual stocks?
Not necessarily.
There is a meaningful difference between:
“I enjoy analyzing businesses and keep individual stocks as a limited part of my portfolio.”
and:
“My retirement depends on my ability to continually identify stocks that will beat the market.”
The first can be a conscious choice.
The second requires a much stronger belief in your investing edge.
Before assuming you have that edge, ask:
- What information am I using that the market may not already know?
- Why should my valuation or forecast be better than other investors’?
- How will I determine whether the strategy is actually working?
- Am I comparing my results with an appropriate benchmark?
- Am I measuring performance after costs and taxes?
Most importantly:
Would I still make this investment if nobody were talking about the stock?
That question will not turn you into a professional investor.
It can help separate an investment thesis from attention and excitement.
Should you copy the “smart money”?
I would not.
Knowing that firms and short sellers were better positioned in a historical dataset is very different from being able to identify their profitable trades in real time.
You also face different information, constraints, costs, taxes, and risks.
Trying to copy corporate transactions or short-selling activity can easily turn the paper into another market-timing strategy.
That misses the bigger lesson.
The paper is interesting precisely because different sophisticated groups did not all agree or perform equally well.
If even identifying who possesses useful information is complicated, the simplest response may be to require a very high bar before believing you personally have found an exploitable signal.
What should a long-term investor take from this?
For me, the lesson is not:
“Retail investors are bad at investing.”
It is:
“Repeated stock selection is a difficult task, and you should have a good reason before making it necessary for your financial plan.”
If you genuinely enjoy researching individual companies, you can decide how much of your portfolio you are willing to expose to that approach.
If you do not enjoy it, do not have the time, or cannot explain why your process should produce an advantage, a diversified fund approach lets you invest without continually predicting which company wins next.
Our guide to low-cost index funds explains what to compare before choosing a fund.
The important word is compare.
Do not select an investment simply because it is labeled passive, low-cost, or diversified.
Frequently asked questions
Why do retail investors underperform?
There is no single explanation.
The 2025 Journal of Financial Economics study found that retail investors as a group tended to buy stocks with lower forecasted returns and sell stocks with higher forecasted returns. Their aggregate trades also predicted subsequent returns opposite to the study’s return signal.
Behavioral factors such as attention and excessive trading may help explain some retail behavior, but they are separate findings from earlier research.
Does the study show retail investors buy losing stocks?
Not exactly.
It shows that retail investors bought stocks with lower forecasted returns and sold stocks with higher forecasted returns relative to the study’s model.
A lower expected return does not mean a stock is guaranteed to lose money, and a higher expected return does not guarantee it will rise.
Are short sellers better investors?
The paper found that short sellers’ trades were aligned with its forecasted-return signal and predicted returns in the intended direction.
That does not mean every short seller is skilled or that ordinary investors should start shorting stocks.
Do corporate buybacks predict higher returns?
The study finds favorable return information in firm trading broadly.
It should not be converted into a rule telling investors to buy every stock announcing a repurchase. The paper does not test such a simple strategy.
Are professional investors better than retail investors?
Not uniformly.
The study did not find a general positive trading signal from institutional investors, while separate SPIVA data show that many active U.S. large-cap funds have historically failed to beat their benchmark over longer periods.
Some professional investors do outperform.
Should beginners invest only in index funds?
There is no investment that is right for every person.
Broad index funds can offer diversification and reduce the need for individual-stock selection, often at relatively low cost. But they still carry market risk, and the appropriate portfolio depends on your goals, time horizon, and tolerance for risk.
Are index funds guaranteed to outperform active funds?
No.
Active managers can and do outperform in individual periods and categories.
The case for index investing is based on diversification, costs, simplicity, and the historical difficulty of achieving persistent active outperformance, not a guarantee that passive funds win every year.
The bottom line
Taking Sides on Return Predictability gives us unusually broad evidence about how different investors position themselves.
Using a forecast built from 193 return predictors, the researchers found that retail investors tended to buy stocks with lower forecasted returns and sell stocks with higher forecasted returns. Firms and short sellers traded more favorably relative to the same signal.
That is an important finding.
But it does not prove retail investors always lose, that firms always know the correct price, or that an index fund will outperform every active strategy.
The practical lesson is more useful when stated modestly:
Stock picking gives you another difficult decision to get right. You should only make that decision central to your portfolio if you have a strong reason to believe it adds value.
For an investor who does not have that edge, a diversified, low-cost index strategy can remove much of the security-selection problem while keeping costs relatively low.
It will not remove market risk.
It will not prevent you from making emotional decisions.
And it will not guarantee higher returns.
But you do not need to identify tomorrow’s winning stock to participate in the long-term returns of a diversified market portfolio, which is a much more defensible takeaway than pretending one study found a guaranteed way to beat the market.
