What Are Institutional Investors, and How Do They Affect Stock Volatility?

Our advice is geared toward helping the individual investor make smart moves in stocks, but in the landscape of the markets, there are also giants: the institutional investors. But what is the border between regular investor and institutional investor, and how much capacity do those deep-pocketed organizations have to make share prices dance? And if the big money hasn't found a stock yet, is that a good metric for considering it "off the radar"?

In this segment of the Motley Fool Money podcast, host Chris Hill and Fool senior analysts Ron Gross, Matt Argersinger, and Jason Moser parse the definitions and consider how the behaviors of institutions ripple across Wall Street.

A full transcript follows the video.

This video was recorded on Nov. 2, 2018.

Chris Hill: Question from David in Massachusetts. He writes, "What is the definition of an institutional investor? Does the percentage of institutional investors indicate if a stock is under the radar? And how do institutional investors affect the volatility of a stock?" Three really good questions, Matty.

Matt Argersinger: Yes. Well, I don't think there's any hard definition of an institutional investor. We think of it as any investor that's not a retail investor or an individual investor like us, or maybe a small RIA investor that's managing family money. We're talking about hedge funds, investment banks, pension funds, big money managers like Fidelity. That's what an institution is.

To the second point, yes. We especially tend to see it with small caps. Small caps tend to not have a lot of institutional ownership. That makes them interesting. They tend to be off the radar because large institutions usually can't invest in them anyway. So maybe you can have a little bit of an informational advantage as an individual investor buying small caps.

Ron Gross: The institutions that are focused on what we call quant investing or algorithmic investing are often very responsible for a lot of the volatility we see. These are folks that manage billions and billions of dollars and will take their portfolios up or down several percentage points with a check mark on a piece of paper or computer. You'll see big, big swings in both stocks and the market as a whole. The importance of indexes, like the S&P 500 Index, so many dollars flowing into those indexes. You'll see wide, wide swings up and down in what people think of as a proxy for the market.

Jason Moser: One of the things we look for in any of the stocks that we're covering for members or recommending for services, you look at the holdings, the companies or the institutions -- who has meaningful ownership in that company? And oftentimes, particularly with new IPOs, you'll see VC interest, venture capital interest. And a lot of times, they can have 5%-10% ownership, even more. That's fine, they helped bring that company public and that helps them, in that regard. But it's also worth remembering, whenever you see that heavy VC interest, they have an exit strategy in mind. By exit strategy, I mean they want to be able to sell that and make some money at some point. They want to realize those gains. That is something worth noting when you see these new IPOs. Take into consideration the fact that there may be an exit strategy at some point here that could, in the short run at least, play its way on the stock price.

Gross: And finally, I'll add that, it's a combination of the institutional analysts, sometimes what we call the sell-side analysts, giving guidance to the institutional investors that will cause stocks to jump or decline in relatively large swings. Most retail investors like us are not focused on these sell-side analysts and the buy-sell-and-hold. But the institutional investors clearly get their guidance from them.

Hill: For individual investors like us, when we're buying a stock, we're going to make a phone call or click a button, and it all happens in one fell swoop. I'm curious, Ron. Back in your hedge fund days, when you were buying shares of a company, I'm assuming you had to do it on a piecemeal basis. You couldn't just go in all at once and buy all the shares you wanted.

Gross: Correct. We would work with traders. We would say, "Let's work a 10,000-share order with a top price of $7 per share," and they would go to work for us. Or if we had smaller orders, we could do them by ourselves through our own systems. But yeah, especially if you're dealing small caps and micro-caps like I did, you've got to work those orders over days, if not weeks.