How Smart is the “Smart Money?”

I have always been fascinated by the consistent data that show that individual investors are pathetic at timing markets. For example, we have all seen the flow data for mutual funds, the investment vehicle of choice for most small, individual investors. From that data we know that individuals tend to pour money into equity mutual funds at accelerating rates near the top of a market and withdraw at accelerating rates near a bottom. has sketched it well here:



So, when I see evidence of this effect in other investment spheres, I am glad that I consciously try to think as a contrarian as much as humanly possible. Of course, one must not act as a contrarian solely for the sake of being a contrarian, but a bottom-up approach and diligent fundamental analysis will frequently expose excellent contrarian ideas.

In Your Money & Your Brain, Jason Zweig cited a study[1] of institutional investors that indicated that the smart money may not be as smart as many unsophisticated individuals believe: 

“A recent study of the hiring and firing of money managers by pension funds, endowments, and foundations found that these ‘sophisticated investors’ consistently hire firms that are on a three-year hot streak. They also fire money managers that are on a three-year cold streak. Ironically, the firms they hire go on to underperform the market, while the firms they fire end up outperforming.” 

So, these sophisticated investors are making decisions the same way as the less sophisticated investors make them: they follow the trend. And you know what they say about trend following: 

“What the wise man does in the beginning, the fool does at the end.” 

It is often hard for individual investors to believe that institutional investors ultimately make decisions the same way as they do. After all, they know that institutional investors spend a lot of their capital on due diligence, consultants, and third-party support, and because of that spending many individual investors believe they have no chance in competition with institutional investors. But, if this study is correct, then the wise individual investor has an edge, and that is one more reason why contrarian value investors tend to outperform. 



[1]Goyal, Amit and Sunil Wahal; “The Selection and Termination of Investment Managers by Plan Sponsors;” EFA 2005 Moscow Meetings Paper; November 2004

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