Is there such a thing as smart money?

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The writer is chair of Rockefeller International

The new movie Dumb Money tries to turn Wall Street’s pecking order on its head, casting professional investors as the dummies and amateurs as the smart ones. Set during the meme stock craze of 2021, the plot ends before the real life story did — with losses for the retail investors who tried to outsmart big hedge funds. Sorry Hollywood, the underdogs did not win. The movie did, however, leave me pondering a bigger question: is there such a thing as “smart money”?

Certainly, most pros don’t beat the market either, and this has been true for decades. Since 2000, there have only been three years in which a majority of large cap funds outperformed. In the 2010s, on average, 8 out of 10 mutual funds and 9 out of 10 institutional funds underperformed in the US markets, after fees. The share of pros who beat the market was only slightly better before fees and was equally low in the stock markets of Europe, Asia and the rest of the world.

Still, the pros do better than retail investors, who make every mistake in the book, and more regularly. They trade on “noise” rather than information, a phenomenon that has probably been exacerbated by rumours flying on online trading sites. The amateurs succumb to familiarity bias, leaning to names they know rather than names they research. They trade on sentiment rather than fundamentals and follow the herd, which tends to stampede towards losses.

The studies are damning. Stocks favoured by retail investors tend to underperform by one per cent — per month. Shares generally do better after they sell than after they buy. And retail investors, especially if they are men, are prone to overconfidence and sensation seeking and thus tend to trade way too often. Within the community of retail punters, the most active 20 per cent of traders earn returns far lower than the least active 20 per cent.

The losses are not just for day traders in individual stocks. Through bad timing, active amateurs lower their returns by 20 per cent when they are pulling in and out of mutual funds.

The pros know all this well. In fact, one strategy they have used with some success is just to watch which way the retail crowd is going and move in the other direction. Yet most pros underperform the market most of the time, too. The market is constantly evolving to reflect a changing economic reality — keeping ahead of it is tough. By some accounts, the performance of the pros has been declining in recent decades because there are so many more of them and so much more capital chasing returns.

If superior intelligence is hard to find, superior information can be had at a price. Another consistent finding: information is “asymmetric”, which is to say the pros have more access to the good, costly variety, as opposed to the free rumours and rants on Reddit.

One of the more interesting insights on information superiority comes from studies of (legal) trading by company insiders. Senior executives tend to sell ahead of abnormal declines and buy ahead of abnormal surges in a company’s shares. Chief executives and chief investment officers tend to do better than less senior executives, probably because they have more complete information. In this well-informed circle, following the herd can work.

Local information can provide a similar edge. In emerging markets, big global funds have often assumed they can teach the locals a thing or two about investing, only to learn humility the hard way. In the run-up to currency crises, my research has found that locals often pull out well ahead of foreign investors and then are the first to return, sniffing an economic turnaround. Superior on-the-ground knowledge gives them an edge.

Still, a narrow elite does produce consistent returns, which requires a fine balance. The most successful ones have a disciplined system for anticipating markets — and the flexibility to change when conditions change. They understand that analysis is important but temperament is more so. Experience matters and they have developed the skill to maximise gains when they are right, which is typically 60 per cent of the time, and to cut their losses the other 40 per cent of the time. They have a view and stick to it, right up till the second it no longer makes sense.

These, however, are the qualities of investment legends. For the rest, there is a pyramid of success, from the reasonably well-informed and experienced pros to their numerous but less able peers, and at the bottom the unfortunate cohort of retail day traders. If there is a movie title that accurately captures the mass behaviour of the investing world, it might be Dumb and Dumber.