Dumb Money Trading Strategy (Backtest)

Introduction: Understanding Dumb Money in Trading

The term “dumb money” in Dumb Money trading strategy refers to a group of investors who are considered to be less sophisticated or experienced than other participants in the market.

These investors may make trading decisions based on emotions, FOMO, herd mentality, or a lack of understanding of how the markets work or what to expect. While the term “dumb money” is often used in a derogatory way, it is important to recognize that these investors play a significant role in market dynamics.

In short, they tend to buy and sell investments at the worst possible time, buying stocks when prices are on the rise and selling those stocks when prices start to decline. Hence, it’s often used as a contrarian indicator strategy.

In contrast, Smart Money refers to big institutional investors and mutual fund companies armed with teams of experienced investment analysts who can evaluate exactly what’s going on in the market, allowing them to make better investment decisions. Smart Money tends to buy and sell at the right time, while Dumb Money tends to buy and sell at the wrong time.

Of course, in reality it’s not as easy as that, but this is the thoery, at least.

Unveiling the Role of Dumb Money

Dumb money traders can influence market prices in several ways.

Their impulsive trading behavior can lead to sudden spikes and dips in stock prices, particularly in volatile or illiquid markets.

Additionally, herd mentality among dumb money traders can amplify the effects of news or rumors, further exacerbating market volatility.

On the other hand, dumb money traders can also provide liquidity to the market, allowing for easier execution of trades. Their trading volume can also contribute to the overall price discovery process, as their buying and selling activity helps to establish fair market prices.

Navigating the Risks and Opportunities

The presence of dumb money in the market creates both risks and opportunities for experienced traders.

By understanding the psychology and trading patterns of dumb money traders, experienced traders can develop strategies to exploit their inefficiencies and profit from their mistakes.

However, trading against dumb money can be risky, as their impulsive behavior can lead to sharp reversals in market direction. An example is the crazy rise in Gamestop in 2021 that sent many professional short sellers to the cleaners:

Gamestop was way overvalued, but it took several years for the price to come down. 

History of the Smart Money Index (SMI)

The Smart Money Index (SMI) (or Indicator), developed by Don Hays, is a technical analysis tool that gauges market sentiment by tracking the performance of the Dow Jones Industrial Average (DJIA) during two key periods: the first half hour of trading and the final hour of trading.

The SMI is calculated by subtracting the DJIA’s gain or loss in the first half hour from yesterday’s SMI value, then adding the DJIA’s gain or loss in the final hour. The SMI can be calculated for any security, but it is most commonly used to assess the overall market trend.

A higher SMI value indicates that the market is being driven by institutional investors, who are often considered to be more informed and sophisticated than retail investors. This is because institutional investors typically make their trades during the first half hour and the final hour of trading, when they have more time to analyze the market.

A lower SMI value, on the other hand, suggests that the market is being driven by retail investors, who may be more prone to emotional trading and may not have as much experience or knowledge as institutional investors.

Smart Money Calculation

Here’s an example to illustrate how the SMI is calculated:

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  Yesterday’s SMI = 100

  
  
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  DJIA gained 10 points in the first half hour of today’s trading.

  
  
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  DJIA lost 30 points in the final hour of today’s trading.

  
  
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  Today’s SMI = 100 – 10 + (-30) = 60

  
  

Therefore, if the SMI value decreases, it suggests that institutional investors are becoming less bullish and may be preparing to sell.

Conversely, if the SMI value increases, it suggests that institutional investors are becoming more bullish and may be preparing to buy.

Assessing the Risks and Opportunities

To effectively navigate the dumb money landscape, traders should carefully assess the risks and opportunities associated with this group of investors.

Here are some key factors to consider:

Market volatility: Dumb money traders can amplify market volatility, making it more difficult to execute trades and increasing the risk of losses. Just look at the chart above showing the price swings in Gamestop. 

Herd mentality: Dumb money traders tend to follow the crowd, which can lead to rapid price movements and increase the likelihood of overreactions. But markets tend to revert to the mean after abnormal swings. 

Lack of experience: Dumb money traders may not have the experience or knowledge, thus increasing the chances of making mistakes.

Psychology of Dumb Money Traders

Understanding the psychology of dumb money traders is essential for successfully exploiting their inefficiencies in the market.

These traders often make trading decisions based on emotions and/or herd mentality.

Emotional Biases

Dumb money traders are often susceptible to emotional biases that can cloud their judgment and lead to poor trading decisions. These biases include:

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  Greed: The desire to make quick profits can lead dumb money traders to buy into overvalued stocks or hold positions for too long, even as the market turns against them.

  
  
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  Fear: The fear of losing money can lead dumb money traders to sell out of stocks prematurely or avoid making any trades at all.

  
  
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  Confirmation bias: The tendency to seek out information that confirms existing beliefs and ignore contradictory evidence can lead dumb money traders to make biased investment decisions.

  
  

However, both professional and retail traders are susceptible to making the same mistakes. It’s called cognitive mistakes, and we have covered the most common trading biases in a separate article.

Herd Mentality

Dumb money traders often follow the crowd, buying stocks that are rising in price and selling stocks that are falling in price.

This is kind of momentum strategy, and we know that momentum has worked on a time frame from one month to max 12 months. However, these retail traders have no knowledge of such a strategy, and they are not putting it into a trading system, like a professional would do. A professional would backtest the trading strategy first, a “dumb” trader has no idea what backtesting is.

Lack of Knowledge

Many dumb money traders lack knowledge. They may not understand fundamental analysis, backtesting, or the risk management principles that are essential for successful trading.

Please also read our short guide on how to instantly improve your trading in 5 steps.

Identifying Dumb Money Traders

Identifying dumb money traders in the market can help traders take advantage of their inefficiencies. Here are some key characteristics to look for:

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  High trading volume: Dumb money traders tend to trade in large volumes, which can move the market price of stocks.

  
  
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  Short-term focus: Dumb money traders often focus on short-term gains and dream of easy money, but no such thing exist. 

  
  
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  Emotional reactions: Dumb money traders may react impulsively to news or rumors, leading to overreactions and large price swings, just like the chart above in Gamestop proves.

  
  

Common Dumb Money Trading Mistakes

Dumb money traders often make a number of common mistakes that can lead to financial losses.

Here are some of the most common mistakes to watch out for:

Overtrading: Dumb money traders often overtrade, entering and exiting positions too frequently. This can lead to high transaction costs.

Chasing trends: Dumb money traders may chase trends, buying stocks that are already rising in price and selling stocks that are already falling in price. This can lead to buying at the top of a market cycle and selling at the bottom.

FOMO (Fear of Missing Out): Dumb money traders may be susceptible to FOMO, buying into stocks that they see rising in price out of fear of missing out on potential gains. This can lead to buying into overvalued stocks or holding positions for too long, even as the market turns against them.

Fear of losing: Dumb money traders may be afraid of losing money, selling out of stocks prematurely or avoiding making any trades at all. This can lead to missing out on potential gains or even locking in losses.

Lack of risk management: Dumb money traders often fail to implement proper risk management strategies. This can leave them vulnerable to large losses in the event of market downturns.

Ignoring fundamental analysis: Dumb money traders may not fully understand fundamental analysis, which is the process of evaluating a company’s financial health and prospects. This can lead to investing in companies that are not fundamentally sound.

Having no plan: Above all, Dumb money traders have no plan in the first place. This is a recipe for disaster in the markets. A bad plan is better than no plan, in our opinion.

Strategies To Profit from Dumb Money

While the term “dumb money” may be derogatory, understanding the psychology and trading patterns can be a trading strategy in itself. 

By exploiting the inefficiencies of dumb money trades, you can increase your chances of making profits. Here are some specific strategies to consider:

1. Trade against the trend: Dumb money traders often tend to follow the trend, buying into overvalued stocks and selling out of undervalued stocks. By trading against the trend, you can potentially capitalize on the corrections that are likely to occur as dumb money traders realize their mistakes. Such mean reverting strategies has worked well in the stock market for the last 40 years. Please check out 3 backtested mean reversion trading strategies.

2. Use technical indicators to identify potential reversals: Technical indicators can help you identify potential points of reversal in the market, where dumb money traders may be starting to lose confidence, such as the RSI indicator, for example. This could be a good time to enter a short position or sell your long position and take profits.

3. Exploit momentum plays: Dumb money traders often get caught up in momentum plays, buying into stocks that are rapidly rising in price. You can take advantage of this by shorting these stocks when they show signs of exhaustion or by selling out of your long positions and taking profits. We have an example of a S&P 500 momentum strategy.

4. Trade based on news and rumors: Dumb money traders are often easily swayed by news and rumors, which can lead to overreactions in the market. 

5. Use social media sentiment analysis: Social media can be a valuable tool for gauging the sentiment of dumb money traders. By monitoring social media conversations about stocks, you can identify potential trends and trade accordingly.

• Impact of Social Factors on Individual Investors’ Trading Behaviour Analysis
• The Twitter Trading Strategy

Examples of Dumb Money Trading Strategies

Here are some examples of specific trading strategies that have been used to profit from dumb money:

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  Short selling: Short selling involves borrowing a stock and selling it with the expectation that its price will fall. This strategy can be effective for exploiting the overvaluation of stocks that are being bought by dumb money traders. However, short selling is extremely difficult, professional or not. But history has shown that stocks with a huge short interest tend to underperform the markets over time.

  
  
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  Trading breakouts: Breakouts occur when a stock breaks out of a trading range. Dumb money traders often follow these breakouts, which can lead to further price gains. 

  
  
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  Trading the news: When significant news releases or rumors are published, dumb money traders often react impulsively. 

  
  

Conclusion: Navigating the Dumb Money Landscape

The presence of dumb money in the market can be both a blessing and a curse for traders.

While it offers opportunities to profit from their mistakes, it also presents risks of sudden reversals and market volatility. As Keynes once said: the market can stay irrational longer than you can stay solvent. There might be many dumb traders, but they are powerful.