by James Heaton and Nicholas Polson
Bloomberg
June 14, 2012
Market observers often divide investors into “smart money” and “dumb money.” Our research shows there may be a way to figure out which group you are in.
The first place to look is prices, which reflect the interaction of smart money and dumb money and may contain valuable information about the proportion of either in the market. In other words, the price knows which category we belong to. The trick is to extract that information.
Consider a simple example of a simple market: betting on a horse race. Say there are two horses, A and B. And there are two types of bettors, smart money and dumb money. We place our bet on horse A because we think it is more likely to win. It turns out that 75 percent of the money is on horse B, and 25 percent is on A. These “prices” can help us learn whether we are more likely to be the dumb money or the smart money.
We want to compare the probability that we are the dumb money given the market price to the probability that we are the smart money given the market price. We can write this as P(dumb|market)/P(smart|market). If this ratio is greater than one, then it is more likely that we are the dumb money. Less than one, we are more likely to be the smart money.
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