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The stock market can be a volatile setting where each investor’s success depends on both strategy and their tactics. In addition, each investor must create a balance between minimizing risk and maximizing returns. Savvy investors know how to navigate fluctuating prices and follow the market’s patterns. They rely on objective data to help them make informed decisions. For example, many traders rely on tools like the Smart Money Index (SMI) to direct their choices. Here’s an overview of the SMI, how it works and whether it’s the right tool for you.

Consider working with a financial advisor to find out about other metrics you can use to understand market movements.

What Is the Smart Money Index?

The SMI, also known as the Smart Money Flow Index, originated in the 1980s when Lynn Elgert described it in a 1988 issue of Barron’s, a weekly published by Dow Jones & Company, Inc. Following that, the index was popularized by Don Hayes, a rocket scientist, during the 1990s.

The index uses technical analysis to measure the market sentiment of investors during the first 30 minutes of trade versus the last hour. It gauges the difference in investing behaviors at these two times, from 9:30 a.m. to 10 a.m. and then from 3 p.m. to 4 p.m.

The standard SMI formula is:

Yesterday’s SMI – opening gain or loss + last hour gain or loss = Current/Today’s SMI

Trades made at the beginning of the day are labeled the “dumb money,” whereas those placed at the end are called the “smart money.”

This isn’t actually a slight against early day traders. Instead, the index tracks intraday price patterns based on investor emotions. It presumes that many traders who make their trades early on or right at the opening bell are reactive and impulsive. They take in news overnight and let it influence their decisions in the morning when they’re panicking.

In contrast, the “smart money” traders wait until the end of the trading day. They spend the day monitoring the stock market and make choices based on their evaluations. Following this line of logic, it would be “smart” to trade near the end of the day since that follows the stock market’s direction.

How to Use the Smart Money Index

Financial advisor studies the SMIThere isn’t a standard system for using the SMI. You can use it to learn when the market is trending towards bullish versus bearish movements. But, there is no defined line that dictates when the market fits in either category. Instead, traders can use the index to look for those trends in the stock market or when it diverges. The SMI identifies or confirms a stock market trend when the market moves align with the SMI. This possibly means that the trend will continue. For example, if the Dow Jones Industrial Average takes a hit, the SMI should also trend lower. This can be seen as a “bearish” move where investors feel pessimistic about the market’s direction.

Alternatively, the market can act in contrast to the SMI. If that happens then the stock market will likely change to fit the SMI eventually. In this scenario, you may see the stock market go down while the SMI trends higher. That would suggest the market will soon follow in a “bullish” move. Divergences directly compare the actions of the “dumb money” and the “smart money.”

Best Practices for Using the Smart Money Index

The SMI shows you where the “smart money” is moving. Therefore, you can adjust your investment strategy to follow similar patterns. If you see the smart money is moving towards more conservative approaches, you can follow that behavior. Likewise, if you monitor the SMI, you can possibly use it as a market predictor.

The best way to appreciate the SMI is to use it against impulse, though. Fear and insecurity can pull you to follow the herd. Use the SMI to double-check whether you’re making a decision based on logic or emotion.

Is The Smart Money Index Right for You?

Every investor has the opportunity to create a personalized strategy for success. It’s up to you to find the tools that complement your approach and are comfortable to use. The SMI is a technical rather than a fundamental analytical tool, so it uses data calculated from short periods to identify patterns. It then uses those behaviors to predict the market’s actions in the future. Since it collects data from a shorter time frame, active traders may benefit from using the SMI.

Furthermore, the SMI benefits traders who want short-term returns. If you are interested in long-term returns, you may want to look into fundamental analysis as you consider a stock instead. This kind of analysis focuses on how the company that issued the shares is doing, its earnings, revenue, debt, etc.

The Takeaway

A female investor checking her portfolio

The SMI is just one of many technical analysis tools investors have at their disposal. You can use it to track the intraday trading patterns of other investors, which can help you make your own decisions. Furthermore, it has the potential to show you whether you are making impulsive trades or “smart money” moves. However, whether it works for you as an index depends on yourself. Certain investors may not find it useful because it doesn’t show them data that helps with long-term investments. Active day traders should determine whether the SMI helps improve their trading decisions or not.

Investing Tips

  • The stock market can be volatile. While it’s important to watch it for patterns, you can take hands-on measures to guard your finances. For example, an asset allocation calculator can help you create and maintain a diversified portfolio that will help buffer your portfolio as the market goes through bullish and bearish phases.
  • A financial advisor can help you avoid impulsive decisions and work with you to create a logical plan. Finding the right professional to support your needs doesn’t have to be hard work, either. SmartAsset’s free matching tool can pair you with local financial advisors who are ready to work through any financial concern you have. If you want to improve your investment strategy today, get started now.

Photo credit: ©iStock.com/Tempura, ©iStock.com/metamorworks, ©iStock.com/Drazen_

Ashley Kilroy Ashley Chorpenning is an experienced financial writer currently serving as an investment and insurance expert at SmartAsset. In addition to being a contributing writer at SmartAsset, she writes for solo entrepreneurs as well as for Fortune 500 companies. Ashley is a finance graduate of the University of Cincinnati. When she isn’t helping people understand their finances, you may find Ashley cage diving with great whites or on safari in South Africa.
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