“Smart Money” Debunked and How You Can Make Consistent Returns
By: Rutvij Thakkar
While there’s an illusion of “smart money” that percolates throughout the finance world, which supposedly represents all institutional investors, there’s little evidence to support the idea that these individuals or organizations are any better at predicting the market than your average retail investor. When I started off investing in public markets, I felt like the lessons taught would put me at some asymmetric advantage for investing, and I felt on top of the world about my due diligence and research and portfolio managing skills. But as an impressionable young person, it was always in my first order of business to feel remarkably capable despite having no real experience in the financial services sector other than some basic equity research books. I never expected that my understanding would bring me to academia and research, but here I am.
Throughout my short journey in finance, I’ve met with many kinds of retail investors, and almost always, there is this same arrogance about how they know more than the mysterious forces surrounding public markets (these people, while they may be entitled to their opinions, are objectively wrong very frequently). There’s also another archetype of individuals in financial markets who believe that institutional money is infallible and that there is no point in trying to beat the markets because the market is so efficient it has already been beaten. I believe part of this premise is correct, but I will contest the idea that smart money always wins. There isn’t real evidence to support the idea that “smart money” even exists. People frequently use superstar investors such as Warren Buffett who have seemingly public track records to differentiate winners from losers. The “institutional money” crowd uses anecdotes of arbitrage conducted by large private wealth managers such as Scion Asset Management’s “Big Short” in 2008 or George Soros’ shorting of the British pound in 1992. But these anecdotes are just that. The wins do not come any easier because of a “hot hand,” and these stories are exactly that: just one-off stories and tales of wins that may never be replicated again. Many investors are especially guilty of this “hot hand” philosophy. They suggest that the methodologies used by superstar investors are ever-lasting. Using the availability heuristic, it’s easy for us to correlate a few institutional wins and generalize their successes as the rule. This is why the value investing philosophies of value investing are still preached regularly, even though Ben Graham has long since passed to opine on whether or not even he would still believe in his attitude. Our structures of belief constantly change with time, befitting the dynamic nature of markets, so it’s not sensible to think that one ideology of investing suffices. From a behavioral economics perspective, Kahneman and Tversky have explored the availability heuristic extensively:
In the original Tversky and Kahneman (1973) research, three major factors that are discussed are the frequency of repetition, frequency of co-occurrence, and illusory correlation. The use of frequency of repetition aids in the retrieval of relevant instances. The idea behind this phenomenon, is that the more an instance is repeated within a category or list, the stronger the link between the two instances becomes. Individuals then use the strong association between the instances to determine the frequency of an instance. Consequently, the association between the category or list and the specific instance, often influences frequency judgement. Frequency of co-occurrence strongly relates to Frequency of repetition, such that the more an item-pair is repeated, the stronger the association between the two items becomes, leading to a bias when estimating frequency of co-occurrence. Due to the phenomena of frequency of co-occurrence, illusory correlations also often play a big role.
This is to say, individuals like forming a correlation because of hearsay that they can simply acknowledge as fact. The repetition frequency is evident in today’s markets, with the same financial literacy titles remaining at the top of the bestseller’s list for decades on end. Rich Dad, Poor Dad, has now been out for almost thirty years, and Intelligent Investor’s first version was published seventy years ago. So it should come as no surprise that these principles are now almost subconscious in most investors’ minds. Price to Earnings Ratio. Money you make < Money you keep. Make your money work for you. Cash flows. Dividends. Margin of Safety. All of these principles have been hammered into the psyches of retail investors for ages to the point where a competitive advantage may not even exist with a singular, un-nuanced method. It may even come to be that no competitive advantage exists at all, but it’s almost a given that no competitive advantage can exist if everyone follows the same rules.
And one thing worth clearing up: Warren Buffett doesn’t follow the same rules as Ben Graham laid out. In 2008 when Buffett made a great deal of his profits with General Electric and Goldman Sachs, he was able to negotiate terms no retail investor would ever dream of. His strategic buy gave him voting rights and activist abilities that made him personally responsible for the output of his investments — this is something no average investor could have access to regardless of how well their due diligence is conducted. So this goes to show that many of us simply miss the bigger picture. But that’s not all, the data supporting the idea of “smart investing” is rather sparse as well. When it comes to mutual fund managers, considered the gurus of wealth management, around 90% of mutual fund managers cannot beat their benchmark index from 2005–2019.
But this isn’t a recent phenomenon, in fact when the ability of institutions to beat the market was first tested in 1968, we can observe the same thing: that there indeed is no consistent professional money management:
This is a blow to many in the financial industry, and typically the defense to this is that “most of the other guys don’t know what they’re doing”, but this claim is just as wrong considering that performance among managers who may be on top one year isn’t consistent in the following years.
Typically right after Morningstar awards a fund manager a performance award, the managers experience a steep decline in portfolio returns. This is another psychological phenomenon along the lines of the availability heuristic that makes managers believe they are know-it-alls in this market. But the fact of the matter is, the chances a manager in the top quartile of performers remains there is very low.
This illustrates better than any anecdotal justification that there’s no consistency in the market, so it’s impossible for people to remain consistent AND successful continuously. We will typically not have the access and influence that activist investors have, so their strategies that typically come with teams of analysts and institutional backing are false equivalencies that simply do not apply to the circumstances of most retail investors.
The primary idea is this: markets will never stick to one model to benefit one person, that simply would not be effective because it would allow arbitrage, or the exploitations of inefficiencies that don’t fall in line with a “perfect” model. But any understanding of financial economics almost requires that you believe the premise of 0 arbitrage because it’s too rare — and why’s that? Because the markets are simply too dynamic. The lesson to take away here should be twofold: save as much as you can, as frequently as you can. Oversaving is rare. The second thing to keep in mind is that institutional money managers aren’t magical — stick to passive indexes and ETFs to make the most “consistent” returns. The only consistency that exists is the benchmark “market” return. Most people can rarely beat this and still maintain their savings, and not to mention many lose their savings in low-interest-bearing accounts. If you’re a real speculator and investor, however, look at any of my other writings.