Dumb Money Bulls Vs. Smart Money Bears

In this article, I will discuss how the dumb money is driving the stock market higher. When reviewing the behavior of dumb money investors, human psychology comes into play. The reason psychology is more important in describing the behavior of dumb money investors than smart money investors is because professional investors are aware of the logical fallacies which can harm performance. This isn’t to say professional investors don’t make mistakes, but at least they’re making a concerted effort to avoid common pitfalls. The other advantage professional investors have is that they do real research based on data. We know dumb money investors are not doing research because they bought stocks at the height of the dot com boom and are repeating the same mistakes now.

The most basic, but most powerful factor in reviewing why the dumb money is so bullish is recency bias combined with herd mentality. The thinking is that everyone is buying index funds and index funds have done well in the past few years so it must be a good decision to get in on. Recency bias effects herds because the herd gets to proclaim how great it’s doing and bash anyone who was skeptical of the rally. When I bring up any factors about the economy or valuations to members of the herd, they get confused. They don’t understand how there could be any bearish factors if stocks are doing well. That justification for being bullish because stocks are up is the very reason why stocks ignore fundamentals.

The chart below shows the historical dumb money weekly investment into the Dow Jones Industrial Average. As you can see, the dumb money is the most bullish it has ever been in this cycle. There was a significant dip in speculation in 2015, but the market was able to hold steady because of zero percent interest rates and cycle peak buybacks in Q4 2015. The jump in dumb money speculation and short covering after the election gave this rally the support it needed as the Fed started to raise rates at a quicker pace.