Are You the Dumb Money?

Dumb investors get caught in a dumb cycle–buying high and selling low.

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In the hit comedy, Dumb and Dumber, Jim Carrey and Jeff Daniels play two guys that are so utterly moronic, that their inanity actually becomes their best asset. Without knowing it, their stupidity guides them past unperceived dangers and smack dab into the middle of unsuspecting success.

If only life worked so charmingly. But in the cold world of Wall Street, the dumb are preyed upon, while the dumber quickly become extinct. Not only is this true, it is actually celebrated as fact by financial mavens and the media alike who have captured this ethos through their invention of the terms smart and dumb money.

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In closed-door discussions from the venture capital industry, through the hedge fund industry, past leveraged buy outs and all the way to traders of simple stocks and bonds, those in the know whimsically discuss what the smart money is doing to get rich, and of course, how the dumb money is helping them get there.

And in the event that you are late to the conversation, in their mind at least, you may be the dumb money. More specifically, the dumb money is the individual investor who watches CNBC for stock tips. It is the investor that gets a hunch, or better yet, at stock tip from a friend and acts upon it. The dumb money is the lemming like masses that plunge off the bluff and into the sea when despair is on tap, and double down on their investment when a sector is running hot.

Like the ocean tides that move in and out with shocking continuity, the pros believe the dumb money to be so predictable, that these hawks consider it a contrary indicator of what the markets are about to do. When the dumb money is rushing madly into gold, the smart money starts writing shorts. When the dumb money is sure that the S&P 500 is dog meat and is running for the door, the smart money grins and starts moving in.

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Fear, Greed and the Dumb Cycle

Dumb investors get caught in a dumb cycle—buying high and selling low. As ridiculous as this behavior sounds, a closer look reveals how the strong emotions of fear and greed can drive even the most determined investor towards this sadly dim-witted behavior.

In any intellectual exercise, like a crossword puzzle, knowledge wins. But in the real world, behavioral scientists have demonstrated that a primal need for rewards and security give tremendous platform to the emotions of both fear and greed.

To understand the dumb cycle, you simply need to understand the role of fear and greed in driving investment decisions. When an investment is returning nicely, the greed gland kicks into overdrive commanding us to buy more of what is working. The investor then sells his poorly performing asset classes and buys more of his winning investment. Likewise, when all hell breaks loose, the fear gland begins to repetitiously squawk like a malfunctioning fire alarm within the investor’s mind. Sell, sell, sell is it commanding instructions. Run for the door.

A simple analysis of inflows and outflows of capital to and from the mutual fund industry easily illustrates this point. In 2000, the dot-com hysteria had people so frothy that they were dipping into their home equity lines to double down on the new gold rush. The NASDAQ ran up to 5,000 and had a one-year return of a shocking 80%. The greed gland was pumping out its buy commands and the masses were moving in perfect harmony. Then, by the fall of 2002, the NASDAQ party came to a crashing halt, plummeting quickly to half it value. Fear was the order of the day and as money rushed out of tech, it moved quickly into bonds that predictably were at a record high. The dumb cycle was complete.

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You Don’t Have to Be Dumb

Although Wall Street might look at you as the dumb money, you can in fact become the smartest money of all. To overthrow fear and greed’s reign of terror, the smart investor must develop principles and policies that will usurp the primal impulses that otherwise lead inevitably to the investment funny farm.

By rooting your portfolio management in highly researched and scientifically demonstrated principles of global asset allocation, disciplined rebalancing and especially staying the course when others are loosing their cool, you become a member of the smart money club.

In seasons of wild market swings, investing takes faith—faith that stocks will do better than bonds, and that bonds will do better than cash, just like they always have. It requires faith that via diversified participation in the global free market, you will benefit from the rigors of millions of workers and thousands of companies striving daily to do well.

While Dumb and Dumber provides a great laugh on the sliver screen, being the smart money provides the best laugh of all.

Steve Beck is cofounder of MarketRiders, an online investment advisory and management service helping Americans invest for retirement. MarketRiders gives investors greater peace of mind knowing that they are leveraging the best thinking of Nobel laureates and the investing methods used by the world's most elite institutions and wealthiest families. MarketRiders is on the investor's side, helping reduce investment costs and risks, and increasing retirement savings.