How Dumb Money Can Become Smart Money

If your broker decided to give you a grade on your trading tactics, based on whether the trades you were making added any value to your portfolio, what kind of marks would you receive? It may seem like an outlandish concept, but one online brokerage did just that – and the results are somewhat surprising. The investors who were graded actually adjusted their trading strategies based on the feedback they received.

Average individual investors who trade money are often shoved under the “dumb money” umbrella. If you fall into this category, try not to take offense. The terms “dumb money” and “smart money” were coined by the financial media, not to insult anyone’s intelligence, but to describe different groups of investors.

Big institutional investors and mutual fund companies are labeled “smart money.” These investors have somewhat of an unfair advantage over your run-of-the-mill individual investor. Armed with teams of experienced investment analysts, “smart money” investors can evaluate exactly what’s going on in the market, allowing them to make more informed investment decisions. This does not necessarily mean they always make smart decisions – in fact, plenty of them make bad trades from time to time. They simply have access to valuable information that allows them to make a more educated choice. 

On the other hand, the average investor generally does not have the time, experience or patience to methodically analyze corporate reports or the global economy. Because these investors don’t have access to teams of analysts or carefully compiled data, they often make trades based on instinct or a gut feeling. Consequently, the “dumb money” group tends to buy and sell investments at the worst possible time. They buy stocks when prices are on the rise and sell those stocks when prices start to decline. For the average investor, the stocks they buy go on to underperform, and the stocks they sell go on to perform very well. Perhaps this is why average investors typically earn 1% to 2% less than the average mutual fund.

One group of researchers took notice of the chronically poor performance of individual investors. Steffen Meyer, Linda Urban, and Sophie Ahlswede, authors of the study “Does Feedback on Personal Investment Success Help?” wondered if offering the investors feedback on their trading decisions would improve their performance. Their study was published by SAFE (Sustainable Architecture for Finance in Europe). 

The idea of providing investors with feedback is somewhat of a novel approach. The authors of the study point out that the vast majority of banks and online brokerages do not offer investors any sort of feedback. According to one survey, only one in 120 German banks regularly informs customers about their portfolio risks, costs and returns each year.

Authors Meyer, Urban, and Ahlswede decided to see what would happen when an online broker offered 1,500 customers repeated feedback on their performance in a monthly securities account report. The test, which spanned a total of 18 months, included investors who traded heavily, with an average annual turnover of more than 100%. During the study, the investors received reports that showed their returns and costs from the previous year as well as their current level of risk and portfolio diversification. 

The end result of the feedback study was encouraging. “We find that receiving a report results in investors trading less, diversifying more and having higher risk-adjusted returns,” wrote Meyer, Urban, and Ahlswede. Additionally, the researchers found that these effects became stronger over time. In other words, the longer the investors received reports, the more likely they were to adjust their strategy and improve performance.

It does not really matter how investors receive this feedback, according to the study; as long as they have access to the information, their performance will improve. “We find that effects did not differ much between the different report designs,” the authors write. “It seems that it is more important to provide investors with relevant feedback, rather than a specific format in which it is delivered.”

The authors conclude that providing feedback reports not only helps online brokerage customers – but the same type of feedback could also assist the average stock market participant. “Our results do not change if we focus on the very literate investors only,” the authors explain, adding that even basic feedback reporting “could help regular stock market participants, who often do not know their costs, diversification, and performance.”

Unlike large institutional investors, the average investor does not have access to a team of analysts and the piles of data they need to make smart, informed trading decisions. As a result, the typical individual investor suffers from extremely poor performance. According to some statistics, over a 20-year period, the average investor earned 2% to 3.5% less than the overall market each year.

Fortunately, this new study offers a shred of hope for average investors. With relevant performance feedback from your broker, you can adjust your trading tactics and improve your performance. So, go ahead: Ask your broker for a grade.

You may also want to read The 3 Most Timeless Investment Principles and Investing 101: Portfolios and Diversification.