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An institutional investor is a business that invests money on behalf of its clients. Institutional investors are considered professional investors and are often generalized as "Wall Street."
Institutional investors are responsible for a lot of market noise, moving billions in and out of investments. Let's go over how they work, the risks of using institutional investing, and how institutions make markets.
Let's start with the different types of institutions and their customers:
Most institutional investors must register with the Securities and Exchange Commission and file regulatory forms both on an initial and ongoing basis. Mutual and exchange-traded funds must report their holdings multiple times per year, and hedge funds must report holdings above a certain dollar amount.
Many institutions aren't allowed to hold ownership positions in stocks that amount to more than 10% of the company. Generally speaking, institutional investors are allowed to invest using financial instruments (for example, leverage and derivatives) that some retail investors can't, as long as they disclose how the instruments will be used.
Here are a few of the risks you take when working with institutional investors:
Institutions make up the majority of volume on the stock market. They invest trillions of dollars each year for beginning investors and accredited investors alike. There are certainly risks to becoming dependent on institutional investors, but they make the market work, and they make it liquid and cheap enough for everyday people to invest.
With the above risks considered, institutional investors are still incredibly important to the market. It literally wouldn't exist without them. Every highly traded exchange has market makers that increase liquidity and drive down transaction costs.
For example, let's say you want to buy shares of Nike (NKE -2.77%). When you put the order in with your broker, it is probably executed immediately. That isn't because you just happened to put the order in simultaneously with another party who conveniently wants to sell the exact same number of shares. It's because a market maker accepted the transaction. Market makers are trading shares throughout every day on the market. They buy shares from one party and then sell them seconds later to another. They aren't trying to make money on the trades; instead, they make money from the bid/ask spread.
When you sell a stock, you receive the bid price of the stock. When you buy, you pay the ask price. For most stocks, these are only a few cents apart, if that much. Market makers are processing potentially millions of transactions each day and make the spread on each. Stocks with more trading volume will have more market makers competing, which drives the bid/ask spread down. More thinly traded stocks have a higher spread, but it's still worth it because you may not have a chance to even buy without it.
