Smart Money

What Is Smart Money?

Smart money is the capital that is being controlled by institutional investors, market mavens, central banks, funds, and other financial professionals. Smart money was originally a gambling term that referred to the wagers made by gamblers with a track record of success.

Understanding Smart Money

Smart money is cash invested or wagered by those considered experienced, well informed, "in-the-know," or all three. There is little empirical evidence to support the notion that smart-money investments perform better than non-smart-money investments; however, such influxes of cash influence many speculation methods.

The term, "smart money" comes from gamblers that had a deep knowledge of the sport they were betting on or insider knowledge that the public was unable to tap into. The investing world is similar. The populace perceives that the smart money is invested by those with a fuller understanding of the market or with information that a regular investor cannot access. As such, the smart money is considered to have a much better chance of success when the trading patterns of institutional investors diverge from retail investors.

Smart money also refers to the collective force of big money that can move markets. In this context, the central bank is the force behind smart money, and individual traders are riding the coattails of the smart money.

In the context of gambling, smart money refers to those who earn a living on their bets; many gamblers use historical mathematical algorithms to decide how much and on what to wager.

Identifying Smart Money

Conventional wisdom holds that insiders and informed speculators typically invest more, so it should follow that smart money is sometimes identified by greater-than-usual trading volume, particularly when little or no public data exists to justify the volume. However, very little evidence exists to confirm that widely-held suspicion.

One source of information that is generated almost exclusively by more informed market participants is the pricing of stock and index options. Such information is complex and confusing to untrained investors and traders so it naturally serves, and is used, by a more informed set of market participants. Knowing who the holders are of smart money and where they are investing can be of great benefit to retail investors who want to ride the coattails of smart money investors.

Some data providers use various methods and data sources to group transaction data from commercial and non-commercial traders. One such source is known as the Commitment of Traders (COT) report. This data is published weekly by by the Commodity Futures Trading Commission (CFTC). Many analysts use this information to divide futures trading activity into actions being taken by better-informed investors. Any such "smart money versus dumb money" chart study should emphasize the recognizable differences in how the two groups position themselves in the market.

However, chart readers should be aware that a chart study that labels price action as smart money or dumb money is prone to invalid characterizations. Not every investing action can relay the investors' intent through the price action alone. Additionally, returns of a given individual, and even most professional portfolio managers, are often unable match the returns of mechanical index investing over time.

The Scale of Smart Money

Investors with large followings, such as Warren Buffett, are considered smart money investors, but the scale of their activities is not always taken into account. When the cash reserves at Buffett's company, Berkshire Hathaway, accumulate and are not invested, this is definitely a sign that Buffett does not see many value opportunities in the market. However, Buffett functions on a different scale. A $25,000 investment is not too significant in a billion-dollar portfolio.

Buffett's smart money acquires companies rather than taking a position. Institutional investors of Buffett's size need scale for overall portfolio impact. Therefore, even when the smart money is out of value picks in the current market conditions, it does not mean that there are no opportunities — particularly for modestly sized stocks.