This blog post has an alternative title: Are you smart or dumb? Are you doomed?
Suppose we take as given that dumb money loses to the smart money. After all, price discovery is a zero-sum game in the capital markets.
Here’s an article by James Heaton and Nicholas Polson that can give you a formula for successful investing. The formula is to know when the price is dominated by smart or dumb money, and whether you’re one or the other.
However, it seems that about half of this article is pretty much circular reasoning. The amount of money bet by the smarts is usually equal to that bet by the dummies; otherwise, the market doesn’t come into equilibrium (for every buy, there’s a sell, or simply Say’s Law). So, practically all of the time, when the market is behaving normally, it is very difficult to tell from the price data alone whether it is dominated by smart or dumb money. Of course, when the market is obviously dominated by one of the twin evils of financial crises – Fear or Greed – we have an idea that the price is dominated by dumb money (and we even know in which way it’s wrong!).
Still, in the later part of their article, the authors point to a useful approach called the Costanza Rule. It works if we have extrinsic evidence that we’re either dumb or smart. This part isn’t so hard. If in the past you’ve been losing relative to the market, you must be dumb. Then you follow the Costanza Rule. That rule requires you to do the opposite of what you would want to do. Voila, you’ve turned yourself from dumb to smart.
Or have you? The new real question is then: Do you have the guts to bet against yourself?