Key Takeaways
- Smart-money indicators such as SMI are used to assess institutional investors’ stock buying behavior for insight into the actions and approaches of such seasoned and informed investors.
- “Dumb money” indicators – retail buying, for example – uncover the movements of investors who are less knowledgeable or more emotionally driven.
- Smart-money investors also tend to have longer-term investment horizons and be professionals at mutual funds, hedge funds, and pension funds.
The term “smart money” has been bandied about for ages, chiefly in gambling as in, “the smart money is on …” whatever. But there is what is called a smart money index used in investing that can demonstrate investor sentiment based on intra-day price patterns.
Smart Money and Dumb Money Demystified
While there is no hard and fast definition, most so-dubbed smart-money investors are privy to a wealth of valuable information and have a number of analysts who conduct due diligence on investment opportunities. Such exploration may include a company’s financials and their competitive position and management team.
Such professional investors also tend to have longer-term investment horizons and have positions with mutual funds, hedge funds, or pension funds. In addition, they frequently focus on industries or sectors expected to experience marked growth and make relatively large investments.
Note that the “smart money” label does equate with success or wise decisions. It is merely how such investors and conduct are labeled.
By contrast, the term “dumb money” refers to investors who are generally viewed as relatively less informed and are often more emotional when it comes to investment decisions. These are typically individual part-time or retail investors who lack the expertise and knowledge of their professional counterparts. For example, such investors may regularly base investment decisions on “hunches” rather than due diligence.
But here, too, “dumb money” is simply a designation, since there are many retail investors who fare better than “smart money” types. Many are trend followers who – by whatever means – often position themselves properly amid major trends.
The Birth of the Smart Money Index (SMI)
In general, smart money indicators are used to assess institutional investors’ stock buying behavior for insight into their actions and approaches.
On the other hand, “dumb money” indicators – retail buying, for example – uncover the movements of investors who are less knowledgeable or more emotionally driven.
One major “smart money” tool, the Smart Money Index (or Indicator), was developed by Don Hays. It may be calculated for any security. Its formula is:
- Calculation of the gain or loss of the Dow Jones Industrial Average following the first half hour of trading.
- Repetition of the first step during the final trading hour.
- The SMI = yesterday’s SMI – the market’s gain or loss in the first half hour of today’s trading plus the today’s market’s gain or loss in the last hour. Use yesterday’s closing price of the Dow on that day for the SMI first value.
To illustrate, consider that the value of yesterday’s SMI was 100. If the Dow gained 20 points in the first half hour and lost 40 points in the final half hour, the SMI’s latest value would be 100 – 20 + (-40) = 80.
Investor Sentiment: More Than Just a Buzzword
“Sentiment.” However vague or even inconsequential the term may seem, paying attention to the conduct of professional investors can be beneficial: it can lead to better returns.
Ultimately, the question is not whether investor sentiment impacts stock prices, but how to best gauge such sentiment and quantify its effects. SMI is one way to do that.
The Flip Side: Criticisms of SMI
Some contend that the Smart Money Index is not wholly understood and that it falls short of being empirical.
Others complain that the indicator assumes that it is mainly retail or part-time investors who trade during the market’s open, while professionals just trade the close. Oftentimes, they contend, this is simplistic and not always correct.
Consulting Investor Sentiment Resources
Resources to help track smart money in the financial markets can include:
- Volume analysis. Analyzing trading volumes from various derivatives and securities can turn up large trades by smart-money investors. Analysis can determine whether smart money is buying or selling.
- Commodity Futures Trading Commission filings. The CFTC requires institutional investors, hedge funds, and other large traders to report their positions in what are known as Commitments of Traders reports, which can provide valuable information.
- Volume analysis. Large trades by smart-money investors can be uncovered through the analysis of trading volumes from varying derivatives and securities.
- 13F Filings. Institutional investors who have north of $100 million in assets under management must each quarter file a 13F with the U.S. Securities and Exchange Commission. Insights may be gleaned from such reports.
Investments with Less Volatility
There is an asset class that, due to its low correlation to constantly fluctuating public markets, are less volatile than stocks – and thus less subject to impact from investor sentiment.
These are “alternative assets” — art, real estate, transportation, private equity, private debt and more. Such private-market opportunities can provide steady secondary income, even during poor market conditions. In fact, private markets have performed better than stocks in every market downturn of almost the last 20 years.
Another key benefit of alternative investments is diversification – spreading one’s investments among, as well as within, varying asset classes. Diversifying holdings can decrease overall portfolio risk and is fundamental to long-term investing success.
