3.9.4. Smart Money

The e fficient markets theory, as it is commonly expressed, asserts that when irrational optimists buy a stock, smart money sells, and when irrational pessimists sell a stock, smart money buys, thereby eliminating the e ffect of the irrational traders on market price. From a theoretical point of view, it is far from clear that smart money has the power to drive market prices to fundamental values. For example, in one model with both feedback traders and smart money, the smart money tended to amplify, rather than diminish, the e ffect of feedback traders, by buying in ahead of the feedback traders in anticipation of price increases they would cause (Shiller 2003). In addition to search costs, investors might choose mutual funds with high expenses if high-expense funds provided better service than other funds.

Barber et al. (2005) asserted that di fferent levels of service are unlikely to explain their results, since first-rate service and low expenses are not mutually exclusive. For example, Vanguard, which is well-known for its low-cost mutual fund o fferings, has won numerous service awards. Barber and Odean (2003) concluded that either models of optimal asset location are incomplete or a substantial fraction of investors are misallocating their assets. Though tax considerations leave clear footprints in the data they analyzed, many households could improve their after-tax performance by fully exploiting the tax-avoidance strategies available on equities.
