Myth #2 - The Myth of Smart Money in the Stock Market

Our series on Mastering the Psychology of the Stock Market continues -

In Part 1, we looked at - and refuted - Myth #1 - Efficient Market Hypothesis:

Efficient Market Hypothesis, or EMH, is the belief that the stock market is highly efficient and "bakes in" all known and relative information.

Ergo, the share price of a stock, at any given time, is a true reflection of value.

The only problem is that EMH doesn't stand up to much scrutiny

>> MOST STOCK CHARTS SURE DON'T LOOK EFFICIENT

Stocks zig and stocks zag, and often by a lot, and just as frequently, they end up right back where they started at.

And that's not a function of information - it's a function of psychology.

>> WARREN BUFFETT

Put simply, if there was any basis for EMH whatsoever, Warren Buffett would've been just another mediocre money manager long since retired and forgotten.

Granted, Buffett no longer consistently outperforms the broader market, but I would argue that says more about the size of Berkshire-Hathaway than it does about the efficiency of stock prices.

(We're going to look at size in terms of "smart money" here as well.)

But Buffett never could have grown Berkshire-Hathaway into what it is today without taking advantage of a stock market riddled with inefficiencies.

In other words, there was no way Warren Buffett could've become Warren Buffett by dollar cost averaging.

>> AN EFFICIENT MARKET SHOULDN'T HAVE EXTREME PRICE SWINGS

For that matter, if the stock market is truly efficient, we would never see wild volatility, flash crashes, extreme sell offs, or sudden melt ups.

Where, for instance, did all that crazy volatility we saw back in January and February come from?

Hint - it came from "smart money" being on the wrong side of a leveraged volatility bet that had to be forcibly unwound.

>> HUMAN PSYCHOLOGY IS AT THE HEART OF EVERYTHING EXCEPT THE STOCK MARKET?!?

Psychology - messy, irrational, psychology - permeates EVERYTHING that involves human beings.

But we're expected to believe that a world comprised almost entirely of money and ego is going to be a rational and reasonable place?

The Myth of Smart Money in the Stock Market

This is one of my favorite topics because it's as fun as it is enlightening.

We are soooo intimidated by what we perceive as authority and power - often to our own detriment.

And needlessly so, for that matter.

So much of "authority" is a facade, so much of it really is something out of the Wizard of Oz where we're instructed to "ignore the man behind the curtain."

Unfortunately, that's what most people do.

(Who knows? Maybe it's fortunate - because it certainly makes our jobs easier.)

In any case, there's this notion out there on Wall Street that professional, sophisticated, institutional investors - aka Smart Money - has a huge edge over all of us dumb retail investing yokels.

Smart money exits a position just as the party's ending while dumb money (that's us) continues to pour in.

And vice versa on bottoms.

After all, smart money has the skills, insights, research staff, insider connections, etc.

So the system is totally rigged against the retail investor.

But is any of this actually true?

Or is it a form of psychological manipulation perpetrated by the managed money industry itself?

Well, let's start poking around and find out . . .

Why Does Smart Money Suck at Investing?

The most damning evidence against so-called Smart Money is its own track record.

Most fund managers - mutual, hedge, and pension - underperform the stock market in any given year.

Yeah, you might argue, but that's only because of mutual funds. Those hedge fund guys are all brilliant. That's where the real smart money is.

Nope - they routinely underperform as well.

In fairness though, hedge funds aren't designed to outperform the market - they're designed to "hedge" or manage and reduce risk and make good returns no matter what.

But frequently, they don't do very well on that front either.

It's a few years old, but here's a fun article from Business Insider on the 10 Greatest Hedge Fund Implosions of All Time.

Too Much Money to Manage

Smart Money's poor performance has nothing to do with a lack of intelligence or a lack of sophistication.

I don't deny that Smart Money has any of the "advantages" listed above.

But Smart Money also has one very significant disadvantage - it has way, way, way too much money to manage effectively.

There comes a point when your assets grow so large that any attempt to exploit a market inefficiency results in you swamping that area of the market and eliminating the inefficiency.

And then - of course - you've got to take your fees from the assets under management.

Presto, before you know it, those years where you do outperform the market, it's as much about luck as investing skill.

Smart Money and Dumb Money Both Blow up the Stock Market

When it comes to blowing up the stock market - as happens from time to time - there's enough blame to go around.

Yes, unsophisticated retail investors are notorious for piling in at market tops and panic selling at market bottoms.

The real estate bubble - and subsequent crash - a decade ago was largely fueled by rampant house flipping and individuals taking on mortgages they had no business taking on.

But who were the morons who created mortgage backed securities (MBS) to leverage all this retail speculative fervor?

Smart Money, that's who.

It was Smart Money that blew up the U.S. (and European) financial systems and directly led to the worst economy since the Great Depression.

Smart Money is a Herd, Too

At some level, we're conditioned to viewing Smart Money as lions and everyone else as a herd of gazelles.

But if you look closely - and with an open mind - what you really see when looking at Smart Money are simply better dressed gazelles.

The One Way Smart Money is Absolutely Brilliant

So if Smart Money really isn't all that smart . . .

• If it produces mediocre returns at best
• If it's capable of blowing up the stock market and the economy in spectacular fashion
• If it exhibits just as much of a herd mentality as the rest of us . . .

Then how the hell did it end up with so much money?

Ah, that's where Smart Money really is smart.

Due to psychology and the law of large numbers, Smart Money has no actual investing advantage in the stock market.

But what it does have is a marketing advantage - over its own clientele.

Smart Money has done a terrific job convincing individuals that investing is too complicated and too risky to do on their own and that it's better to leave it to the "experts."

And they've structured the system so that they get compensated by HOW MUCH money they manage rather than by HOW WELL they manage it.

This is what you truly must understand:

Smart Money makes its billions not from superior investing skills, but from all the fees it collects.

Mastering the Psychology of the Stock Market Series - What's Next?

In our next installment (Part 3) of our Mastering the Psychology of the Stock Market series, we explore another important topic - secular markets (i.e. secular bull markets and secular bear markets).

It's a psychologically fascinating topic, to be sure.

But beyond that, there's a pragmatic element to recognizing the nature of secular bull and secular bear markets that will give you an enormous edge in the stock market over your entire life.

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