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Smart money is defined as the dollars bet or invested by people, individually or collectively, with expert knowledge on a subject. In the world of finance this generally refers to hedge fund managers, institutional investors, or business insiders with billions of dollars at risk. I’m here to tell you that the general concept of smart money is a misguided term and exhaustive attempts to outsmart the financial markets often end underperformance.
The media and financial institutions sell a story. There are television channels devoted to the stock markets. Media personalities like Jim Cramer opine on the best times to buy and sell. Trillions of dollars flow to institutions with managers and analysts tasked with picking the best investments and filtering out the worst. Hedge fund managers are viewed as billionaire savants with their fingers on the strings of the financial markets.
But that is a misleading narrative. Picking and choosing the investments that will perform the best or worst is an almost impossible task to perform with consistency regardless of the manager’s sophistication or resources.
Warren Buffett has famously stated as much when he challenged a hedge fund manager to select a portfolio of hedge funds that could outperform a buy and hold strategy of an S&P 500 index fund over a ten-year period. In other words, according to the terms of the bet, Warren Buffett would put his money in an S&P 500 index fund and leave it alone. This is the dumb money bet. Anyone could do it. On the other side, the hedge fund manager would spread the money between a series of funds that allocated money between one hundred different hedge fund managers. These funds of hedge funds are typically expensive and only for high net worth investors. They are the ultimate in smart money investing.
Following up on the initial bet in his 2017 annual letter to shareholders, Mr. Buffett noted that in the nine years since the bet started, the S&P index fund has generated a compounded average return of 7.1% per year -- a total return of 85.4% as of the end of 2016. Whereas the funds selected by the hedge fund manager have experienced total gains of only 22%. In nine years the dumb money has outperformed the smart money by more than 63%.
This is just one example but highlights the futility of trying to pick the best stocks yourself or trying to hire the person that can pick the best stocks on your behalf. Instead of seeking out the best returns, or trying to outperform an index, seek out the allocation that is most suited to your goals. If you are going to hire an advisor (which can be a very smart thing), look for the person that helps you find the allocation that you are comfortable holding through good times and bad, keeps things tax efficient, and separates emotions from your investments. If you can do that, and maintain the strategy, you will be far more likely to achieve your financial dreams than the person that spends every waking hour trying to keep up with the smart money.
This article is from the five-part series on the Most Common Investing Mistakes.
Investing does not have to be complicated but far too often, individuals take risks they don’t understand, trying to outperform a benchmark that has no relevance to their financial goals. This series is focused on simple things savers can do to improve their long-term performance.